The Evolution of the â•œSouthwest Effectâ•š

The Evolution of the “Southwest Effect”

The Honors Program

Senior Capstone Project

Student’s Name: Daniel Webb

Faculty Sponsor: David Ketcham

May 2012

Table of Contents

Introduction ............................................................................................................................... 1

Literature Review ...................................................................................................................... 4

Methodology ........................................................................................................................... 13

Results ..................................................................................................................................... 14

Conclusions ............................................................................................................................. 22

Future Research ....................................................................................................................... 22

Bibliography ............................................................................................................................ 24

The Evolution of the “Southwest Effect”

Senior Capstone Project for Daniel Webb

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ABSTRACT

The “Southwest effect” - a large decrease in fares paired with an increase in traffic - has been

discussed around the airline industry since the term was first coined in a government study in

the early 1990s. But the airline industry has drastically changed since then - Southwest has

become the largest domestic airline, and many of its competitors have had the chance to

restructure through bankruptcy.

This study examines some of Southwest's latest city additions, as well as a few of the airline’s

intra-California routes where it is now a dominant player. Using publically-available

government data, the change in passengers and average fare was measured. The change in

average fare was also evaluated with a two-sample t-test, while the difference in distribution

of fares was evaluated with the Kolmogorov-Smirnov test. The results indicate that Southwest

can stimulate traffic and lower fares, the effect of its entrance into a new market decreases

over time. In addition, an analysis of some key intra-California routes indicates that the

opposite of the “Southwest effect” can happen once Southwest becomes the dominant player

on a route.

INTRODUCTION

Since its founding forty years ago, Southwest Airlines has been known for launching

aggressive levels of service in short-haul, point-to-point markets across the country, such as

routes within Texas and California. On many of these routes, significant increases in

passenger volumes are paired with large decreases in average fares. A 1993 paper from the

Department of Transportation’s Office of Aviation Analysis labeled these market shifts as the

“Southwest Effect.”

There has been little research on this phenomenon in recent years. Since the paper’s original

publication, Southwest’s route network has drastically changed. The carrier has entered new

regions of the country, such as the Northeast in the mid-1990s, and has also begun flying

longer routes. In fact, the airline’s average stage length has increased by more than 33% over

the past ten years.

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In addition, in recent years Southwest has re-tooled its revenue management

techniques,started carrying more connecting passengers, and rationalized capacity in some

markets in response to higher fuel prices and a generally weak national economy. Meanwhile,

the carrier has also launched service to markets it has typically avoided, such as Boston, New

York-LaGuardia, and Philadelphia.

In addition, Southwest’s costs have evolved as the carrier has grown.Perhaps more

importantly, major airlines like Delta, United, and most recently, American, have had the

chance to adjust their cost structures during the bankruptcy process, affecting Southwest’s

competitive edge in the process. In a recent letter to employees, Southwest CEO Gary Kelly

said the airline must bring “costs down through increased productivity to compete against

these new legacy airlines.” He also wrote: “Their costs are much lower than they were. Their

labor costs are lower than ours. Actually, they aren't what you would call legacy airlines.

They are new. They are different. The old legacy airlines are dead and buried,” (Maxon,

2011).

With these events in mind, further research of the “Southwest Effect” seems is quite

appropriate. The topic is constantly discussed in various forms of media when Southwest

launches a new market (Grantham, 2010). The “Southwest Effect” has also been referred to

by Southwest management in certain political dealings(Securities and Exchange Commission,

2011).

There also appears to be a gap in the research of this phenomenon. Based on a literature

review, it appears that most researchers have focused on the entry of Southwest, or another

low-cost carrier, on a market, but have not thoroughly examined the long-term effects of

Southwest’s presence in a market, especially one where incumbent carriers exit in the face of

new competition. The original researchers of the Southwest Effect expressed concern about

such a scenario, arguing that “without a competitive discipline, over time Southwest's fares

will increase to cover cost inefficiencies that will creep in, and to extract monopoly profits,”

(Bennett & Craun, 1993).

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Senior Capstone Project for Daniel Webb

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This capstone project will analyze multiple Southwest markets, but will largely focus on

Southwest’s new markets, like Boston, New York-LaGuardia, Minneapolis, and Milwaukee.

Here one could examine the effects of Southwest’s entry into a new route where it did not

already have a significant presence in one of the cities. Also included in the analysis is

Southwest’s intra-California service, which was the main subject of the original “Southwest

Effect” research. Southwest’s market share in these markets has greatly increased since the

initial study, especially as other airlines like United have cut their competition with Southwest

on these routes. Also included will be some of Southwest’s short-haul routes out of

Philadelphia, a market where Southwest has begun trimming its schedule(O'Tolle, 2011). A

study of these routes is useful in determining how the Southwest effect has changed over

time.

Previous studies have focused on the entrance of Southwest in airline markets. This research

will examine the long-term effects of Southwest’s entrance, to see if the initial stimulus

persists for a significant amount of time, especially if competing carriers reduce or eliminate

their presence on a route in response to the entry of Southwest.

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LITERATURE REVIEW

A 1993 research paper written by Randall D. Bennett and James M. Craun (1993) of the

Department of Transportation’s Office of Aviation Analysis was the first to coin the term

“Southwest effect,” a decrease in average fare and increase in volume after Southwest

launches a new route. The two researchers utilize many examples of intra-California routes to

display this phenomenon. For example, they note that the average fare on flights from

Oakland to Ontario decreased 60%, while traffic increased 300% (Bennett & Craun, 1993, p.

7).

Bennett and Craun show that Southwest’s growth had major effects throughout the entire

industry by comparing the average fares for markets of certain stage lengths to the

government-calculated Standard Industry Fare Level. They note a dramatic decline in industry

short-haul fares(Bennett & Craun, 1993, p. 5).

The researchers note that Southwest’s low prices are made possible thanks to a significant

cost advantage relative to other airlines. The carrier with the costs closest to Southwest,

America West, had stage-length adjusted unit costs 20% higher than Southwest. Costs for

other airlines were about 50-70% higher than Southwest (Bennett & Craun, 1993, p. 3).

Bennett and Craun also express concern about Southwest’s actions in a market over the long-

term. They warn that after Southwest dominates a market, the airline could begin raising

fares. To avoid such a situation, they advocate for additional competition in these markets

(Bennett and Craun, 1993, p. 9).

Timothy M. Vowles(2001) examines Southwest’s effect on cities that are served by more than

one airport. Southwest has often utilized alternate airports to serve other cities, such as

Baltimore to serve the Washington, DC area.(Since publication of the study, Southwest has

launched service to Washington-Dulles, thought its operation there is much smaller than

Baltimore’s.) Vowles proposes that Southwest’s entrance at an alternate airport can have an

effect on the main airports. For example, after Southwest launched service from Providence to

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Baltimore, fares to Washington-Dulles and Washington-National also decreased (Vowles

255). Vowles also examines markets with service to both Chicago O’Hare (a hub for

American and United) and Chicago Midway (one of Southwest’s largest focus city). Vowles

notes that traffic between Louisville and Chicago Midway increased 6431%, while traffic to

O’Hare declined despite fares being cut in half (Vowles, 2001, p. 256).

In their paper “City Pairs vs. Airport Pairs: A Market-Definition Methodology of the Airline

Industry,”Jan K. Brueckner, Darin Lee, and Ethan Singer(2010) examine the effects of LCCs

on alternate airports, such as Manchester and Providence on Boston. Such research is useful

as Southwest has avoided some major airports. For example, the airline serves the Miami area

through Ft. Lauderdale and West Palm Beach. The research attempts to determine if some of

these alternate airports should be grouped together to make up one market, a question that is

very important for domestic aviation regulatory policy. Such research also implies how much

an effect Southwest’s presence at alternate airports has on airports served by legacy carriers.

They find that in some cases, alternate airports should not be grouped with major airports,

such as Providence and Manchester and Boston. But in some cases, airports like Miami and

Fort Lauderdale should be grouped together, though West Palm Beach should be considered

independent(Brueckner, Lee, & Singer, City-Pairs vs. Airport-Pairs: A Market-Definition

Methodology for the Airline Industry, 2010, p. 42).

D.E Pitfield’s (2008) study, “The Southwest Effect: A time-series analysis on passengers

carried by selected routes and a market share comparison,” attempts to quantify the effects of

Southwest’s entry into a market using statistical models. It is especially worthy of note as the

paper is one of the most recent research papers on the “Southwest Effect.” Pitfield’s research

primarily focuses on market share data on five routes, and finds that Southwest is able to

quickly grow its share in some markets. In two cases, Southwest’s market share nears

20%(Pitfield, 2008, p. 119).

Pitfield’s data, however, is based on the Department of Transportation’s T-100 Domestic

Market data set, which could distort market share numbers. For example, Southwest might

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have a flight from Chicago (Midway) to Baltimore that continues on to Orlando. If I were to

examine the Chicago – Baltimore data in T-100 Market, passengers that continue on to

Orlando would be excluded. All passengers that deplane in Baltimore, however, are counted,

including those connecting onto other flights. On city pairs like Chicago-Washington in

Pitfield’s study, connecting traffic might be a large portion of passenger volume and affect

market share data. This factor is especially worthy of consideration in this market, especially

as both American and United operate hubs at Chicago O’Hare. Replicating this study with the

DOT’s DB1B data set, which tracks origin and destination (O&D) passengers could be a

better choice that yields some interesting results.

Research from Austan Goolsbee and Chad Syverson (2004) indicates that Southwest need not

provide nonstop service on a route to provide fare relief consumers, as existing carriers will

adjust their pricing to the threat of new competition:

…incumbents do indeed react to the threat of Southwest’s entry before actual

entry takes place. Incumbents drop fares significantly in anticipation of entry.

This is not simply due to airport-specific cost shocks because fares drop on

threatened routes relative to incumbents’ fares on other routes from the same

airports. The fare declines are accompanied by a sizable increase in the number

of passengers flying the incumbents’ threatened routes. The fare decreases are

largest for routes that are concentrated beforehand, but do not decrease at all

for routes into neighboring airports in the same MSA (i.e., where Southwest is

not directly threatening entry). There is only weak evidence that the

incumbents expand capacity (the number of available seats and flights), but

there is strong evidence that load factors increaseon those flights they

have…The findings of this paper suggest that Southwest Airlines has a

powerful competitive effect in the U.S. passenger airline industry, and that this

effect does not operate solely through Southwest’s head-to-head competition

with major carriers (Gooslbee and Syverson, 2004, p. 17).

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Overall, the two researchers find in markets where Southwest begins competing with a legacy

carrier, fares are lowered by 26% (Gooslbee and Syverson, 2004, p. 9).

Recent research byJan K. Brueckner, Darin Lee, and Ethan Singer (2010)in their paper

“Airline Competition and Domestic U.S. Airfares: A Comprehensive Reappraisal” examined

the effect of low cost carriers on average fares. While many studies have focused solely on

Southwest, this paper examines on other low cost carriers, such as AirTran, Frontier, and

JetBlue, as well. They find that LCC competition significantly reduces fares, but that

Southwest often reduces fares the most:

Several broad conclusions emerge from the empirical analysis. First, the

impact of LCC competition is dramatic. The presence of in-market, nonstop

LCC competition reduces fares by as much as 34 percent in the nonstop

markets, and adjacent LCC competition in these markets reduces fares by as

much as 19 percent. The strongest effects come from Southwest, which is

usually separated from other LCCs in the regressions. By contrast, the effect of

legacy competition is slight. An additional legacy carrier providing nonstop

service lowers fares by at most 4.1 percent in the nonstop markets, with no

effect in some specifications. When an additional legacy carrier offers adjacent

nonstop service, the fare impact in the nonstop markets is insignificantly

different from zero in many specifications(Brueckner, Lee, & Singer, Airline

Competition and Domestic U.S. Airfares: A Comprehensive Reappraisal,

2010, p. 5).

Depending on the model used by the researchers, Southwest’s impact relative to other LCCs

is significant. One model for nonstop flights suggests that Southwest’s presence lowers fares

about 28%, while the reduction for other LCCs is 13% (Brueckner, Lee, & Singer, Airline

Competition and Domestic U.S. Airfares: A Comprehensive Reappraisal, 2010, p. 20).

An October 2011 paper by Kerry M. Tan (2011) also examines the effects of a low-cost-

carrier’s entry into a new market, and notes that the simulative effects in an airline market

The Evolution of the “Southwest Effect”

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brought about by the entry of Southwest can similarly occur when other airlines enter, writing

that “JetBlue Airways and AirTran Airways demonstrate how other low-cost carriers can

mirror the entry effects exhibited with Southwest Airlines.”Tan also argues that the “the

Southwest Effect can no longer be considered as a special case relevant to one particular

airline, particularly as it pertains to legacy carrier incumbents” and that “the entry effect

pertains to low-cost carriersin general,” (Tan, 2011, p. 16).Tan notes, however, that in general

Southwest tends to have the greatest effect on pricing of all incumbents when it enters a

market:

“…incumbents tend to decrease their mean airfares the quarter before entry,

the quarter of entry, and the quarter after entry. Southwest Airlines had the

largest average entry effect, with the aforementioned result of inducing

incumbents to decrease prices by 12.24%, on average, the quarter after actual

entry. Other low-cost carriers had similar, yet weaker effects. AirTran Airways

induced a decrease of 10.81%, while incumbents also reacted to entry by

JetBlue Airways and Spirit Airlines, but only by a modest amount of 5.57%

and 5.36%, respectively. Nevertheless, each low-cost carrierinduced

incumbents to decrease their prices before and after actual entry,” (Tan, 2011,

p. 14).

Tan’s analysis examines the twelve quarters prior to entry, the quarter of entry, and the

following twelve quarters. Interestingly, the effect of Southwest’s entrance into a

market diminishes over time, though a statistically significant decrease in fares is still

observed.

Tan further examines the response of legacy carriers when low-cost carriers like Southwest,

JetBlue, or Spirit enter a market and finds that they “respond to entry by low-cost carriers by

dramatically decreasing their average airfares,” and that the response of legacy carriers to

low-cost carriers is greater than recorded when all types of incumbent carriers are considered

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(Tan, 2011, p. 14). Interestingly, Tan discovers that the strongest response by legacy carriers

is seen when AirTran, recently acquired by Southwest, enters a new market:

“Southwest Airlines induces incumbents to decrease their average prices by

13.09%. However, AirTran Airways induces an even stronger effect than that

of Southwest as incumbents cut their mean airfare by an average of 13.31% the

quarter after AirTran Airways actually enters a route. Entry by JetBlueAirways

and Spirit Airlines invokeslegacy carrier incumbents to decrease their prices by

7.07% and 7.98%, respectively,” (Tan, 2011, p. 14).

Tan also analyzes the DB1B data to estimate the effect on entry of a low-cost carrier on low-

cost carrier incumbents, and finds that “low-cost carrier incumbents do not significantly alter

their mean airfare.”

In addition to examining mean airfares, Tan also looks at changes in 10

percentile airfare

and the 90

percentile airfare in response to low-cost carrier entry. Airlines typically offer

numerous fare buckets in any given market, and can potentially adjust some more than others

in response to a new-entrant competitor. For example, discount fares (perhaps located in the

percentile) might be lowered more in response to new entrants, while not changing higher

(sometimes refundable) fares in the 90

percentile. Like the decrease in mean airfares, Tan

notices a significant decrease in fares charged by legacy carriers in response to LCC entry:

“...legacy carrier incumbents slash their 10th percentile prices

immediatelybefore and immediately after entry. In the quarter after Southwest

Airlines actually enters aroute, legacy carrier incumbents decreased their 10th

percentile prices by 11.56%, on average,relative to the excluded period (the

thirteenth to sixteenth quarter before entry). Other low-cost entrants induced

similar effects, with legacy carrier incumbents dropping prices by an average

of8.09%, 7.49%, and 7.69% when AirTran Airways, JetBlue Airways, and

Spirit Airlines entered the route, respectively. These results suggest that legacy

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carrier incumbents significantly decreasetheir discount prices in response to

entry by a low-cost carrier,” (Tan, 2011, p. 17).

The analysis of 10

percentile fares for LCCs in response to the entrance of another LCC are

similar to what was seen in mean airfares. Tan reports that “low-cost carriers do not

significantly alter their 10th percentile prices in response to entry by a rival low-cost

carrier,”(Tan, 2011, p. 17).

Tan notes similar effects in the 90

percentile, or highest, fares:

“Southwest Airlines induces legacy carrier incumbents to decrease their 90th

percentile prices by 14.86%, while legacy carriers decreased their 90th

percentile price by 14.68% and 14.05% in the quarter after actual entry by

AirTran Airways and Spirit Airlines, respectively. Interestingly, these effects

are of similar magnitudes than that on the 10th percentile prices. Full fare

prices charged by legacy carriers decreased by 3.35%, on average, in response

to entry by JetBlue Airways. Although this is not as strong as their effect on

10th percentile prices, entry by JetBlue Airways still put downward pressure

on the incumbents’ full fare prices,” (Tan, 2011, p. 18).

Tan also notes, however, that in terms of 90

percentile fares, “low-cost carriers do not

strongly respond to entry” by another LCC.

Charles Boguslaski, Harumi Ito, and Darin Lee in a 2004 study attempts to evaluate

Southwest’s entry decisions into a market, and notes that over the course of the 1990s

Southwest’s market entry decisions changed over time:

After successfully exploiting a number of very dense short-haul markets,

Southwest expanded into medium-haul vacation markets by tapping into many

customers who had previously not traveled on these routes. We also found that

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starting in 1995, Southwest began entering into a number of relatively thin,

long-haul markets that it had previously avoided. Likewise, we found that

Southwest’s entry decisions during the latter half of the 1990s became more

strongly inﬂuenced by network effects. However, Southwest’s network is

markedly different from that of traditional hub-and-spoke carriers, in that their

route system tendsto be far less concentrated,” (Boguslaski, Ito, & Lee, 2004,

p. 349).

Like other researchers, Kai Hüschelrath and Kathrin Müller explain in a 2011 paper that other

LCCs, not just Southwest, can stimulate markets they enter:

“…our analysis suggested that, first, Southwest cannot be considered as the

only significant low-cost carrier anymore since several other members of this

group showed equal or even more significant effects of entry. Although it

seems likely that part of this result is driven by Southwest’s (and JetBlue’s)

outstanding reputation – leading the respective incumbent carriers to

substantial price reductions as soon as it becomes sufficiently likely that one of

those carriers will eventually enter the respective route (i.e., before the actual

entry event) – entries by other low-cost carriers are found to cause substantial

drops in the average market yield in the quarter of entry. Second, due to its

merger with the low-cost carrier America West in 2005, US Airways must be

considered as a hybrid carrier positioned between network carriers and low-

cost carriers,” ( Hüschelrat & Müller, 2011, p. 27).

It is worth noting, however, that these authors write that in their “empirical analysis of entry

patterns and effects of entry, regional airlines are excluded from the analysis,” and argue that

“most of those smaller airlines operate in small feeder traffic markets,”( Hüschelrat & Müller,

2011, p. 5). Such a statement has become less true over the year as the regional airline

industry has dramatically shifted over the past decade.

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Mainline carriers have been able to reach agreements with their pilot unions that allows for

the flying of larger (roughly 70-90 seats) regional jets by outsourced airlines. In addition,

American, Delta, United, and US Airways have added first class seating to at least a portion

of their larger regional aircraft, harmonizing the product with mainline service. Mainline

carriers have used such aircraft to enter into large business markets, such as Delta Air Lines’

shuttle service from Chicago-O’Hare to New York-LaGuardia.

By excluding regional carriers, these researchers have potentially ignored market entries by

mainline carriers, and have also ignored the possibility of mainline carriers mixing regional

service with their own. For example, comparing Southwest’s performance in the Providence-

Philadelphia market with US Airways while ignoring regional carriers would exclude most of

US Airways’ capacity in the market from the analysis.

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METHODOLOGY

This capstone project will utilize multiple Department of Transportation (DOT) data sources

to analyze Southwest’s passenger volume, revenue, and costs. DOT-published data is not only

comprehensive and free, but is also utilized by many other academic research papers covering

the airline industry.

The quarterly Origin and Destination survey (DB1B) data set, the most important for use in

this study, is based on a 10% sample of all airline tickets and contains fare and routing

information on individual itineraries. This database contains a sample of itineraries across the

country, and contains the number of passengers and fare for each itinerary. This data can then

be aggregated to calculate the average fare in a market and the total number of origin and

destination (O&D) passengers traveling between two cities.

DB1B also contains fields to filter out connecting itineraries, which is useful as this study will

focus on direct flights. The DOT includes other useful fields to help filter the data. For

example, the government agency flags certain itineraries with “non-credible” fares, which are

usually quite high outliers. Itineraries with multiple ticketing carriers (interline itineraries) and

bulk fares have also been eliminated.

It is very important that only O&D passengers be considered for this study, as raw traffic

numbers will skew the results. For example, solely examining the traffic numbers on the

Providence-Philadelphia route after Southwest’s entry would not provide meaningful results.

Many of the passengers flying this route on US Airways are connecting to other cities in the

US Airways network, and as such are not impacted by Southwest’s entry in the route. It is

only valid to study passengers who are actually flying between the two cities.

While average fares are certainly interesting and worthwhile to examine for this research, it

will also be useful to examine the distribution of fares in a market. A wider distribution of

fares charged in a market could be an indicator of Southwest’s attempt to more effectively

utilize revenue management techniques to exact the highest revenue possible from passengers.

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The most basic way to test for the presence of the “Southwest effect” is to look for the

percentage change in passengers (listed as pax in data tables) and average fares. In addition,

two types of statistical tests have been used to aid the analysis of the selected markets. The

first is the Kolmogorov–Smirnov test, which will be used to compare the empirical

distribution functions of fares from two different time periods. The test generates the statistic

D, or the maximum distance between the two distribution functions. As such, higher levels of

D would be expected when the greatest change in fares seen. A simple pooled two-sample t-

test is also used to examine the magnitude and significance of the change in fare.

RESULTS

Boston

Market

Base

Period

Comp

Period

Pax

Change

Avg.

Fare

Change

D

KSp‐

value

Tscore

TP‐

value

BWI 20091 20101 149.1%‐27.4% 0.221118 <.0001 48.78 <.0001

BWI 20091 20111 98.4%‐25.9% 0.326721 <.0001 40.08 <.0001

CHI* 20091 20111 42.8%‐21.3% 0.305002 <.0001 35.30 <.0001

CHI* 20091 20111 36.4%‐4.4% 0.137670 <.0001 6.93 <.0001

DEN 20092 20102 41.8%‐10.8% 0.253779 <.0001 12.98 <.0001

DEN 20092 20112 51.8%‐6.1% 0.214994 <.0001 7.64 <.0001

PHX 20101 20111 81.2%‐23.8% 0.322618 <.0001 16.41 <.0001

STL 20092 20102‐10.5% 16.3% 0.301967 <.0001‐10.91 <.0001

STL 20092 20112‐33.8% 27.0% 0.519334 <.0001‐17.52 <.0001

PHL 20094 20104 510.1%‐52.8% 0.455430 <.0001 84.35 <.0001

*Includes MDW and ORD

For over a decade, Southwest did not serve Boston and told its customers to fly into

Providence or Manchester instead. In 2009, however, the airline changed its mind and began

serving Boston, initially from Baltimore (BWI) and Chicago-Midway (MDW), and service to

other cities followed.

Philadelphia experienced the largest increase in passengers and the largest (and most

significant) decrease in fares. This market alone would indicate that the “Southwest effect” is

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alive and well, and that Southwest can certainly stimulate a market when it wants to. But

Southwest eventually decided to cease service on the route earlier this year, suggesting that

the low fares being charged were the airline were not particularly sustainable.

Baltimore also experienced an increase in passengers and the biggest decrease in fares. Such a

result is not surprising, especially since JetBlue began service on the route later in 2009. It

should be noticed, however, that the increase in passengers and decrease in fares was less in

the next period compared. A similar situation can be found in the Denver market.

In one market, St. Louis, passengers decreased and fares increased after Southwest’s entrance.

Some of this change could perhaps be attributed to American’s dropping of the route. Today,

Southwest is the only airline to serve the city pair.

The Chicago market is also notable – as one would expect, passenger numbers rose and fares

decreased after Southwest’s entry. The difference in fares, shrunk significantly as the market

matured. For example, the t-score for fare difference was 35.30 for a comparison of 2009 with

2010, but it shrunk to 6.93 for 2009 and 2011. The distribution of fares also shows this

change. The 2010 fare distribution (the green line) is much further to the left than the 2009

distribution (the blue line), but the 2011 distribution is much closer to 2009 levels.The D

statistic generated by the Kolmogorov-Smirnov test confirms this, as distance from the 2009

distribution decreased from 0.31 in 2010 to 0.14 in 2011.

The Evolution of the “Southwest Effect”

Senior Capstone Project for Daniel Webb

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

$50 $100 $150 $200 $250 $300 $350

PercentofPassengers

Fare

BOS‐CHIFareDistirbutions1Q2009‐2011

2011 2010 2009

Milwaukee

Market

Base

Period

Comp

Period

Pax

Change

Avg.

Fare

Change

D

KS

P‐value

Tscore

TP‐

value

BWI 20091 20101 50.77% 0.70% 0.111385 <.0001‐0.63 0.5259

BWI 20091 20111 25.65% 24.19% 0.410165 <.0001‐16.62 <.0001

MCI 20091 20101 197.30%‐53.03% 0.571590 <.0001 36.39 <.0001

MCI 20091 20111 160.92%‐44.95% 0.409495 <.0001 29.18 <.0001

MCO 20091 20101 27.92%‐10.93% 0.254915 <.0001 19.31 <.0001

MCO 20091 20111 28.06%‐1.30% 0.159703 <.0001 2.13 0.0335

Southwest entered Milwaukee during a time of heated competition, as AirTran had quickly

built up a Milwaukee focus city that competed with Midwest Airlines’ hub. AirTran’s

presence seems to have tempered the effects of Southwest’s entrance. The change in average

fares to Orlando, a city served by both Midwest and AirTran, was not particularly

drastic.There was also passenger growth to Baltimore (where AirTran was the only

competitor), but average fares were essentially unchanged between the first quarter of 2009

and 2010. In addition, there was not a large change in the distribution of fares.

- 16 -

The Evolution of the “Southwest Effect”

Senior Capstone Project for Daniel Webb

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

$50 $100 $150 $200 $250

PercentofPassengers

Fare

MKE‐BWIFareDistributions,1Q2009/2010

2009 2010

The largest changes in the average fare, number of passengers, and distance between fare

distributions was seen on the Kansas City route, where Southwest was only competing with

Midwest. While only a few routes are being analyzed here, the changes in the Milwaukee

market indicate that at some times, the effects of a Southwest entry are minimized by the

presence of another low-cost carrier.

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

$50 $150 $250 $350 $450 $550

PercentofPassengers

Fare

MKE‐MCIFareDistributions,1Q2009/2010

2009 2010

- 17 -

The Evolution of the “Southwest Effect”

Senior Capstone Project for Daniel Webb

- 18 -

Minneapolis-St. Paul

Market

Base

Period

Comp

Period

Pax

Change

Avg.

Fare

Change

D

KS

P‐value

Tscore

TP‐

value

CHI 20083 20093 53.00%‐61.54% 0.728878 <.0001 193.79 <.0001

CHI 20083 20103 40.15%‐50.27% 0.622310 <.0001 147.43 <.0001

CHI 20083 20113 34.36%‐44.41% 0.509076 <.0001 125.85 <.0001

STL 20092 20102 44.06%‐19.47% 0.250479 <.0001 18.70 <.0001

STL 20092 20112 41.10%‐17.32% 0.332355 <.0001 15.89 <.0001

DEN 20091 20101 22.05%‐12.51% 0.312960 <.0001 22.00 <.0001

DEN 20091 20111 31.15%‐3.51% 0.246585 <.0001 5.34 <.0001

It is clear that Southwest stimulated traffic from Minneapolis to Chicago and St. Louis, and

also significantly reduced fares. These two effects, however, became more muted as time

passed. In addition, according to the D statistic generated by the Kolmogorov–Smirnov test

decreased as time passed, showing that the distance between two fare distributions decreased

as the markets developed further.

Of the three markets examined, Denver experienced the smallest increases and passengers and

decreases in fare. This effect could perhaps be attributed to the fact that Frontier Airlines,

another low cost carrier, was also serving the market. Like the Milwaukee-Orlando and

Milwaukee-Baltimore examples, the results in this market suggest that the effect of

Southwest’s entry is more muted when low-cost carriers are already providing competition.

New York-LaGuardia (LGA)

Southwest started service from LaGuardia in 2009 with service to Baltimore and Chicago-

Midway. LaGuardia is one of the few slot-controlled airports in the United States, and as a

result it is very difficult to obtain access. Southwest was able to acquire LaGuardia slots from

bankrupt carrier ATA Airlines to start eight daily flights.

Market

Base

Period

Comp

Period

Pax

Change

Avg.

Fare

Change

D

KS

P‐value

Tscore

TP‐

value

BWI 20091 20101 667.92%‐36.58% 0.500440 <.0001 10.68 <.0001

BWI 20091 20111 292.45%‐26.62% 0.516464 <.0001 6.88 <.0001

CHI 20091 20101 49.29%‐24.93% 0.433096 <.0001 59.21 <.0001

CHI 20091 20111 58.65%‐12.00% 0.188263 <.0001 30.23 <.0001

The Evolution of the “Southwest Effect”

Senior Capstone Project for Daniel Webb

- 19 -

Baltimore-LaGuardia is an outlier in this study because there were huge increases in traffic

paired with higher fares. This result is likely due to the fact that there was very little capacity

between the two cities. Once Southwest entered the markets, some passengers may have

switched from flying to other (higher-fare) flights to other Washington, DC airports to

Baltimore instead. Nevertheless, the huge traffic increases decreased as Southwest raised fares

further.

Southwest’s entrance into the LaGuardia-Chicago market certainly stimulated it, providing

passenger growth and fare decreases that were highly statistically significant. Fares began to

rise again, however, as the market began to mature.

Newark

The Department of Justice required that some slots at Newark be divested in order for the

merger between Continental and United to be approved. As a result, a deal was struck for

Southwest to receive the slots and begin service. Southwest first launched service to Chicago

and St. Louis.

Market

Base

Period

Comp

Period

Pax

Change

Avg.

Fare

Change

D

KS

P‐value

Tscore

TP‐

value

CHI 20103 20113 23.90%‐8.77% 0.213975 <.0001 14.63 <.0001

STL 20103 20113 95.94%‐32.90% 0.303105 <.0001 26.66 <.0001

Southwest stimulated both markets, but the effects of its entry were greater in St. Louis. The

greater effect in this market could be attributed to the competitive situation on these routes:

Chicago is served by both United and American, while St. Louis is only served United.

It should be noted, however, that Southwest’s Newark station has been open for slightly more

than a year, and as a result this market should be re-visited in the future. At the time of this

writing, there is not enough data to examine some of the other markets served from Newark,

like Denver and Houston.

Oakland

The Evolution of the “Southwest Effect”

Senior Capstone Project for Daniel Webb

- 20 -

This study has primarily focused on Southwest’s new markets, but three major Oakland routes

were also examined to link this research back to prior examinations of Southwest. The

original DOT study that coined the term “Southwest Effect” focused on intra-California

routes, many of which involved Oakland. The authors of the study, NAMES, warned that the

“Southwest Effect” could wear off over time. “Without a competitive discipline, over time

Southwest's fares will increase to cover cost inefficiencies that will creep in, and to extract

monopoly profits,” they argued.

The intra-California market has shifted greatly since the Southwest effect was originally

studied, as legacy competitors have reduced their presence. United Airlines, for example, had

created the airline-within-an airline United Shuttle to better compete with Southwest, but

ended up dropping the concept. As a result, Southwest was left with a monopoly on many

routes. Three major intra-California markets were examined to judge recent developments:

Market

Base

Period

Comp

Period

Pax

Change

Avg.

Fare

Change

D

KS

P‐value

Tscore

TP‐

value

LAX 20053 20073‐10.28%‐0.71% 0.357053 <.0001 2.91 .0036

LAX 20053 20093‐49.75% 13.27% 0.397915 <.0001‐44.70 <.0001

LAX 20053 20113‐53.39% 42.56% .524078 <.0001‐117.81 <.0001

ONT 20053 20073‐3.83%‐2.11% 0.291614 <.0001 7.12 <.0001

ONT 20053 20093‐33.64% 13.08% 0.35046 <.0001‐34.48 <.0001

ONT 20053 20113‐42.93% 48.20% 0.555755 <.0001‐104.17 <.0001

BUR 20053 20073 2.56%‐2.54% 0.375436 <.0001 11.46 <.0001

BUR 20053 20093‐21.05% 12.14% 0.438665 <.0001‐40.58 <.0001

BUR 20053 20113‐29.89% 41.26% 0.598319 <.0001‐125.03 <.0001

All three markets have seen passengers decrease along with fare increases of increasing

significance. In addition, the D statistic increased in each market, showing an increased

difference in the fare distributions. In all three markets, Southwest either now has a monopoly

or carries the vast majority of passengers. The results in these three markets would indicate

that the authors’ concerns over 20 years ago were justified.

Of particular note is the significant decline in passengers on the Oakland-Los Angeles route is

attributable to multiple factors. Increasing fares on the route could certainly temper demand,

The Evolution of the “Southwest Effect”

Senior Capstone Project for Daniel Webb

but increased competition on the San Francisco-Los Angeles route is another factor.

Southwest resumed service at San Francisco in late 2007, and its initial batch of destinations

included Los Angeles. Start-up carrier Virgin America inaugurated service in the same year,

and Delta entered the market in 2009.

Since more airlines have started the SFO-LAX route and some have ended the OAK-LAX

route, the relationship between the two routes has greatly changed. Early last decade, there

were significantly lower fares on the OAK-LAX route, and many more passengers flew this

routing than SFO-LAX. Today, however, the opposite is true: OAK-LAX fares are higher,

and more passengers fly SFO-LAX.

50%

100%

150%

200%

250%

20%

40%

60%

80%

100%

120%

140%

20021

20023

20031

20033

20041

20043

20051

20053

20061

20063

20071

20073

20081

20083

20091

20093

20101

20103

20111

20113

OAK‐LAXPaxas%ofSFO‐LAXPax

OAK‐LAXfareas%ofSFO‐LAXFare

OAK‐LAXFares/PassengersComparedtoSFO

Fare(LHAxis) Passengers(RHAxis)

The distribution of fares in the intra-California markets also experienced changes. For

example, there was very little variation in fare, especially among higher fares, in the Oakland-

Ontario market in 2005. The distribution of fares in 2011 is quite different. The standard

deviation of fare in the third quarter of 2011 was $47.10, more than double its 2005 value.

- 21 -

The Evolution of the “Southwest Effect”

Senior Capstone Project for Daniel Webb

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

$40 $70 $100 $130 $160 $190 $220

PercentofPassengers

Fare

OAK‐ONTFares,2005vs.2011

2005 2011

CONCLUSIONS

Only a sliver of Southwest’s massive network was examined in this study, but many

important conclusions can be drawn. First, Southwest has continued to stimulate traffic and

lower fares on some of its new routes, but these effects appear to wear off after time as these

new markets mature. In addition, these affects can be muted if strong competition, especially

from a low-cost carrier, already exists on a route. Additional analysis indicates that once

Southwest dominates a market, the carrier begins to increase prices, resulting in decreased

demand.

FUTURE RESEARCH

In an industry as dynamic as the airlines, there are always opportunities for further research of

many topics. One interesting topic is the expansion of Spirit Airlines, which calls itself an

ULCC, or ultra-low cost carrier. The airline has recently added flights that compete with

Southwest’s in markets like Chicago-Minneapolis and Los Angeles-Las Vegas. The fact that

another airline is now attempting to undercut Southwest shows how much Southwest has

- 22 -

The Evolution of the “Southwest Effect”

Senior Capstone Project for Daniel Webb

- 23 -

changed over the past few years. Much of Spirit’s domestic expansion, however, has been

very recent, and as a result there is not much government data to study.

Southwest’s acquisition of AirTran last year will also provide an opportunity for further

research, especially in terms of judging how Southwest adjusts AirTran’s business model.

While there have already been plenty of changes, especially the elimination of service at

many smaller airports, many steps in the integration remain. For example, Southwest

continues to maintain the AirTran brand, and passengers are still not able to connect between

the networks of the two airlines.

The Evolution of the “Southwest Effect”

Senior Capstone Project for Daniel Webb

- 24 -

BIBLIOGRAPHY

Hüschelrat, K., & Müller, K. (2011, October). Discussion Paper No. 11-059: Patterns and

Effects of Entry in US Airline Markets. Retrieved December 2, 2011, from Centre for

European Economic Research: http://ftp.zew.de/pub/zew-docs/dp/dp11059.pdf

Securities and Exchange Commission. (2011, February 25). Retrieved February 25, 2011,

from Testimony of Gary C. Kelly, Chairman, President & CEO of Southwest Airlines

Before the Subcommittee on Antitrust, Competition Policy & Consumer Protection:

http://www.sec.gov/Archives/edgar/data/92380/000119312511047009/d425.htm

Bennett, R. D., & Craun, J. M. (1993, May). The Airline Deregulation Evolution Continues:

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Boguslaski, C., Ito, H., & Lee, D. (2004). Entry Patterns in the Southwest Airlines Route

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Brueckner, J. K., Lee, D., & Singer, E. (2010, June). Airline Competition and Domestic U.S.

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whitepaper.pdf

Brueckner, J. K., Lee, D., & Singer, E. (2010, October). City-Pairs vs. Airport-Pairs: A

Market-Definition Methodology for the Airline Industry. Retrieved from

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Pairs%20VS.%20Airport-Pairs.pdf

Gooslbee, A., & Syverson, C. (2004, October). How do Incumbents Respond to the Threat of

Entry on Their Networks? Evidence from the Major Airlines. NET Institute Working

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Grantham, R. (2010, October 2). ‘Southwest Effect’ Heads for Atlanta. Retrieved February 25,

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Muse, L. (2002). Southwest Passage: The Inside Story of Southwest Airlines' Formative

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Senior Capstone Project for Daniel Webb

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Pitfield, D. (2008). The Southwest effect: A time-series analysis on passengers carried by

selected routes and a market share comparison. Journal of Air Transport Management,

14(3), 251-258.

Tan, K. M. (2011, October 4). Incumbent Response to Entry by Low-Cost Carriers in the U.S.

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http://web.econ.ohio-state.edu/~tan/research/LCCentry_KerryTan.pdf

Vowles, T. M. (2001, May). The “Southwest Effect” in Multi-Airport Regions. Journal of Air

Transport Management, 7(4).

Ziegler, S. (2010, March 5). Southwest effect is kicking in at MSP. Retrieved February 25,

2011, from Star Tribune: http://www.startribune.com/business/86689742.html