(PDF) Public Benefits and Private Success: The Southwest Effect Revisited

Electronic copy available at: https://ssrn.com/abstract=3016047

Darden Business School Working Paper No. 206

PUBLIC BENEFITS AND PRIVATE SUCCESS:

THE SOUTHWEST EFFECT REVISITED

Alan R. Beckenstein, Ph.D.

Professor of Business Administration

Darden School of Business

University of Virginia

Brian M. Campbell, Ph.D.

Principal

Campbell-Hill Aviation Group

Alexandria, VA

Date Written: August 9, 2017

Minor Edit August 10, 2017

Electronic copy available at: https://ssrn.com/abstract=3016047

2

PUBLIC BENEFITS AND PRIVATE SUCCESS:

THE SOUTHWEST EFFECT REVISITED1

Abstract

After Southwest Airlines was formed in 1967 and commercial operations began in 1971

the Company was engaged in 31 judicial and administrative proceedings through 1976 that

challenged its right to operate. From its beginning the Company delivered a simple product with

exceptional consumer value – low fares, high frequency of service, single aircraft type, simple

product design, and a fun and friendly experience.

Virtually every market entered by Southwest experienced a significant reduction in average

market fares due to Southwest’s low fare initiatives, and passenger volumes responded

disproportionately. The U.S. Department of Transportation’s landmark study in 1993 captioned

this price-traffic stimulation phenomenon the SOUTHWEST EFFECT. Southwest began by

serving three markets within the state of Texas and a fleet of four B737 airplanes. In July, 2017 it

served 703 nonstop markets and 101 airports, using more than 700 B737 airplanes.

This study reviews the framework for gauging the effect of entry (and potential entry) on

markets for domestic air travel in the US. It provides an empirical survey of routes entered by

Southwest from its beginning to the present. The presence and magnitude of the Southwest Effect

has endured through time. Even today, when new markets have frequently been affected already

by Southwest’s fares on connecting services, the Southwest Effect still shows, on average, an

additional market fare reduction of 15% and corresponding traffic increase of 28% to 30%, from

the introduction of nonstop service by Southwest.

A few industry writers have questioned whether the Southwest Effect still exists today, or

has it been overtaken by the fares/traffic effect created by other low cost carriers. The answer is

clear. The Southwest Effect is alive and well. We find no evidence that the Southwest Effect has

been eroded or overtaken in significance or magnitude by other airlines. This study set out to

demonstrate in quantitative terms the Southwest Effect over the past four decades. Using

regression analysis we developed a model to measure the current impact on market fares due to

competition from Southwest. Our study finds that Southwest produces $9.1 billion annually in

domestic consumer fare savings. One-way average market fares are $45 lower when Southwest

serves a market nonstop than when it does not. If Southwest provides only connecting service in

a city-pair market, average market fares are $17 lower (one-way) than when there is no competitive

effect from Southwest.

1 This report was prepared by Alan R. Beckenstein, Ph.D., Professor of Business Administration at the Darden

School of Business, University of Virginia; and Brian M. Campbell, Ph.D., founder and Principal, the Campbell-Hill

Aviation Group, LLC. The time and effort expended to prepare this report was provided by the authors without

compensation from any party. The research methodology, analytical findings and written observations and

conclusions are solely those of the authors.

Electronic copy available at: https://ssrn.com/abstract=3016047

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Table of Contents

Section Title Page

1.0 THE STAGE WAS SET .................................................................................................... 1

1.1 The Fight for Survival ................................................................................................... 2

1.2 Growth as an Intrastate Airline.................................................................................... 3

1.3 Deregulation? Sort of! ................................................................................................... 4

1.4 Some Key Economic Drivers of Competition in the

Domestic Airline Industry ..............................................................................................6

2.0 CORE PRINCIPALS FOR SUCCESS ............................................................................. 9

3.0 SUMMARY OF THE DOT FINDINGS AND

OTHER MARKET EXAMPLES ................................................................................... 14

3.1 Early Post-Deregulation .............................................................................................. 14

3.2 The DOT’s Study of the Southwest Effect ................................................................. 16

4.0 THE SOUTHWEST EFFECT SINCE THE 1993 DOT REPORT ............................. 19

4.1 Examples of the Southwest Effect during the 1993-2010 Time Frame ................... 20

4.2 Demonstration of the Southwest Effect in Recent Times ......................................... 24

4.3 Significant Restructuring by the Legacy Airlines ..................................................... 28

5.0 A SPECIAL CASE: DALLAS MARKETS AND REPEAL OF THE

WRIGHT AMENDMENT ............................................................................................... 30

6.0 COMPREHENSIVE ANALYSIS OF RECENT MARKETS ENTERED BY

SOUTHWEST AND CHANGE IN MARKET FARES AND PASSENGERS ........... 35

7.0 FARE IMPACT MODEL AND THE SOUTHWEST EFFECT ................................. 39

Exhibits

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1.0 THE STAGE WAS SET

When Southwest Airlines launched jet service in June, 1971 the underlying pre-conditions

for a successful low fare airline in Texas were already present. It took the wisdom and confidence

of Herb Kelleher2 and Rollin King to see it and act upon it. On the back of a cocktail napkin they

drew the initial route structure and set about to create their airline. One of the first things they did

was to recruit Lamar Muse3 to be chief executive officer in January 1971. Muse was an excellent

choice because he was tough, determined and a finance person. He was also a Texan with deep

roots in the Houston and Dallas communities.

By 1971 most major airlines (“trunk” carriers) had converted to jet fleets so passengers

were accustomed to jets and actually preferred them. This also meant that the tremendous cost

savings and fare impacts had worked their way through the system sufficiently to demonstrate the

enormous power of price as a stimulus for increased air travel. In 1971 the airline industry was

highly regulated by the Civil Aeronautics Board (“CAB”) as to market entry, pricing, labor

protection, and mergers. The regulatory structure protected inefficient airlines and caused

passenger fares to be higher than needed for an adequate return for the more efficient carriers.

Passenger services were indirectly regulated because their costs were part of the CAB-approved

fares to which all interstate airlines4 had to adhere.

Some of Rollin King’s motivation for creating Southwest, and his confidence in the

viability of a low fare intrastate airline serving Dallas, Houston and San Antonio, came from his

observation of the successes of Pacific Southwest Airlines (“PSA”) and Air California (“Air Cal”).

Both were profitable intrastate airlines serving many O&D markets within California offering low

fares and high frequency, often in competition with each other in the larger markets. However,

unlike the California airlines, Southwest had to endure many challenges to its fundamental right

to exist.

2 Herb Kelleher was counsel to Mr. King who believed an intrastate airline connecting Dallas, Houston, San

Antonio, and other Texas cities was needed.

3 Mr. Muse had been a successful airline CEO and successful executive at American, Trans Texas, Central, Southern

and Universal Airlines.

4 Those regulated by the CAB.

5

1.1 The Fight For Survival

From Southwest’s incorporation in 1967 through 1976 the Company was engaged in 31

judicial and administrative proceedings that challenged its right to operate as an intrastate air

carrier, its right to operate at Dallas Love Field (“DAL”), and its right to fly interstate routes from

DAL, among other challenges.5 At least one case was heard by the Texas Supreme Court and two

cases went to the U.S. Supreme Court. On the administrative side, challenges to Southwest’s right

to operate were brought before the Texas Aeronautics Commission (“TAC”) and others came

before the U.S. Civil Aeronautics Board.

In the late 1960’s the challenge to Southwest receiving intrastate operating authority from

the TAC was driven by Braniff, Trans Texas (later renamed Texas International), Continental, and

their political supporters. They made the same decades old argument that incumbent carriers

always made in CAB route cases – the markets have an abundance of service already; to add

another airline would ruin the market for everyone; and, the consumer will therefore be a loser as

well. Initially the TAC approved Southwest’s application for an intrastate operating certificate.

Braniff, Trans Texas and Continental filed in Texas state court for a temporary restraining order

and received it. Ultimately Southwest prevailed, but not until the case reached the Texas Supreme

Court, and then, on appeal, to the U.S. Supreme Court which refused to hear the case.

The next set of legal challenges dealt with Southwest’s right to continue to operate at Love

Field after Dallas/Ft. Worth International (“DFW”) opened in 1974. The cities of Dallas and Fort

Worth had earlier agreed upon the site for a new airport to serve both cities and agreed to close

their existing airports to scheduled airline service (Dallas Love Field and Greater Southwest

International Airport) once DFW was open for business. In order to support the financing of the

new airport, all the airlines then serving Love and Greater Southwest International had signed a

bond ordinance committing to transfer all of their service to the new DFW once it opened in 1974.

Southwest did not want to move to DFW and it held the position that it was not legally

required to do so. As a non-operating company in 1968 it had never signed the DFW bond

ordinance and no court or administrative tribunal had ordered it to do so. As its competitors moved

their operations from Love Field to DFW in 1974, Southwest remained at Love and had the facility

to itself.

5 For a brief, but excellent summary of the key legal challenges see Nuts, Kevin Freiburg and Jackie Freiburg, 1966,

pages 16-27.

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In June, 1972 the cities of Dallas and Fort Worth, along with the Regional Airport Board,

filed suit in Federal Court to evict Southwest Airlines from Love Field once DFW opened. The

DFW airlines led by Braniff, Texas International and Continental joined in the suit. Southwest

prevailed in Federal District Court, the U.S. Fifth Circuit Court of Appeals, and ultimately the U.S.

Supreme Court. The Company was finally free to operate at Love Field as a Texas intrastate

airline.

1.2 Growth As An Intrastate Airline

After a tenuous and challenging start in June, 1971, with only $7 million of equity capital,

Southwest gradually expanded to many cities throughout the state of Texas. The Company became

profitable in 1973 and has been profitable every year since.

As shown in Chart 1.1 below, Southwest’s system revenue grew by 1,252% and its O&D

passengers and number of flights increased by 1,042% and 418% respectively from 1972 through

1978.6

Chart 1.1

Southwest Airlines

Growth in Intrastate Texas Markets: 1971 - 1978

Revenue

(000)

Net

Profit(Loss)

(000)

O&D

Passengers

(000)

ASM’s7

(Millions)

RPM’s8

(Millions)

Flights

Departures

No. of

Cities

Served

1978

$ 81,065

$ 17,004

3,528

1,556

1,049

54,816

10

1977

49,047

7,545

2,340

1,011

676

35,415

9

1976

30,966

4,939

1,539

619

406

22,311

4

1975

22,828

3,400

1,136

477

298

17,552

4

1974

14,852

2,140

760

314

184

12,382

3

1973

9,209

175

543

261

131

10,619

3

1972

5,994

(1,591)

309

264

73

10,576

3

1971

2,129

(3,753)

109

155

25

6,051

3

Source: Southwest Airlines, annual reports to the shareholders.

6 “O&D” is shorthand for origin and destination passengers or traffic. It usually signifies one-way travelers; that is

a person traveling from City A to City B as the origin and destination of this trip. A personal traveling from A to B

and back to A is thus two one-way passengers in the O&D statistic.

7 “ASM’s” is shorthand for available seat miles flown. A 120-seat plane flying a 500 mile segment produces 60,000

ASM’s (120 x 500).

8 “RPM’s” is shorthand for revenue passenger miles. So, 100 paying passengers on a flight going 500 miles

represent 50,000 RPM’s (100 x 500).

7

While the State of Texas was large enough to sustain growth to a point, ultimately

Southwest needed to expand beyond the borders of Texas to become a larger carrier capable of

competing effectively with trunk line and local service carriers (the CAB regulated airlines).

Nevertheless, so long as Southwest remained an intrastate airline whose economic regulator was

the TAC, and not the federally created CAB, it could continue to set fares and services as it wished.

Southwest would not surrender its pricing freedom to the CAB under any circumstances. In 1978

airline deregulation was imminent. It offered a win-win solution that permitted pricing and route

freedom. It offered an exceptional growth opportunity for Southwest, with one significant

exception – expansion at Dallas Love Field. Airline deregulation also gave birth to many other

low cost carrier entrants, like Midway Airlines and PeopleExpress.

1.3 Deregulation? Sort Of!

During the 1976-1978 period there were many congressional hearings in both the House

of Representatives and the U.S. Senate to consider and debate economic deregulation (market entry

and pricing) of the domestic airline industry. Interestingly, the whole deregulation movement was

sparked by another young airline entrepreneur, Fred Smith, founder and CEO of Federal Express,

after the CAB rejected FedEx’s application for a Part 401 operating certificate.9 The incumbent

airline holders of Part 401 certificates, along with their labor unions, political supporters, and many

other parties opposed deregulation. Some political leaders, academics, and even regulators were

in favor of some form of airline deregulation. But at the outset it did not look promising.

Professor Alfred Kahn served as Chairman of the CAB in 1977-78. He recruited a group

of very talented microeconomists to work to deregulate domestic airline markets. They

recommended that the CAB be disbanded ultimately, and route entry and fare-setting be left to the

free market rather than by CAB regulation. They prepared the ground work for the legislation that

followed. It also was a crucible for deregulation of other markets. For example, rail freight

deregulation was accomplished by the Staggers Act of 1980.

9 From its start-up in 1973, FedEx’s interstate operating authority was restricted to an air taxi license, which limited

severely the size of aircraft it could fly.

8

Over two years, or more, the opposition subsided and some key players like United Airlines

actually became supporters. Finally, Congress passed the enabling legislation and in October,

1978 President Carter signed into law the Airline Deregulation Act of 1978 (the “ADA”).10

The ADA should have allowed Southwest Airlines to operate freely as a federally

certificated interstate carrier. Unfortunately, opposition to Southwest having freedom at Love

Field appeared quickly. Right after deregulation Southwest applied to the CAB for authority to

fly between Love Field and New Orleans, its first interstate route, and was granted this authority.

However, its application was strongly opposed by Fort Worth Congressman Jim Wright who was

majority leader of the House of Representatives. Since Congressman Wright lost his petition to

the CAB, he went to the floor of the House and persuaded a majority of congressmen to pass a bill

that would ban all interstate service at Love Field. After months of lobbying, a compromise was

reached. In an amendment11 to the International Air Transportation Competition Act of 1979,

airlines were permitted to fly between Dallas Love Field and points in Texas and the four

contiguous states (Louisiana, Oklahoma, Arkansas and New Mexico). However, they were

prohibited from selling through-service to points beyond those states. Beyond-market fares had

to be the separate one-way fares for the two segments. A passenger originating at Love Field and

going to Kansas City with a connection at Tulsa, Oklahoma, had to check in again (with their bags)

at Tulsa, and the total trip fare was the sum of two individual local fares.

It was ironic that the Wright Amendment was passed into law just after passage of the

ADA, the purpose of which was to deregulate the airline market. It was an aberration based upon

the ability of powerful forces in Texas to protect themselves from competition by Southwest, to

the detriment of consumers.

Over the 35-year period from 1979 to 2014, a few minor relaxations to the Wright

Amendment restrictions were enacted by Congress that accorded Southwest some additional

nonstop market opportunity at Love Field (e.g. Love Field to/from points in Mississippi and

Missouri). But significant and complete deregulation of nonstop domestic service at Love Field

did not occur until October, 2014. Today the airport still suffers from two major limitations – both

the result of political horse trading over the Act to repeal the Wright Amendment in 2006. First,

10 The law deregulating the air cargo and express industry was enacted in 1977, and Federal Express became free to

acquire its first group of B727-100 freighters.

11 Known as the “Wright Amendment.”

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Love Field’s gate capacity was reduced from 32 to a maximum of 20 in an effort to protect the

airlines using 165 gates at DFW and there is no limitation on future gate expansion at DFW.

Second, international service is prohibited at Love Field. Notwithstanding the severe restrictions

on Love Field capacity and air service, Southwest has been able to schedule 180 round trips per

day utilizing 18 of the 20 gates. Since repeal of the Wright Amendment took effect in October,

201412 Southwest has added 62 daily round trips13, net of some flight cancellations, and it

inaugurated new nonstop service in 4014 markets.15

The history of Southwest Airlines is a testimony to the vigor of competition in producing

better market outcomes. Southwest’s strategy and commitment to low fares became a force for

the social virtues of a deregulated domestic airline industry. The Low Cost Carrier (LCC) business

model, created by Southwest, became a recipe for unleashing independent forces of competition

that benefitted consumers as well as local, regional and national economies. This was important

for an industry that had a history of structural problems related to perpetual overcapacity and poor

financial performance. Regulation by the CAB had blocked free market experimentation. Despite

the virtues of deregulation, politics in Texas was allowed to bar full freedom for a portion of the

industry. Southwest persisted to build a national franchise without full freedom at its home base

(Love Field). It took thirty-six years before Love Field was finally freed of most of the Wright

Amendment constraints, a lesson for future policy makers.

1.4 Some Key Economic Drivers of Competition in the Domestic Airline Industry

To formalize some of the economic drivers of competition in the airline industry, let us

first consider the route structure. Origin and Destination (O&D) city-pairs--including all airlines

in the same effective region--define the principal arena of competition. However, potential

12 Wright Amendment Reform Act of 2006, PL 109-352, October 13, 2006.

13 Innovata schedules, August 2014 compared to August 2017 mid-week round-trips, accessed via Diio. Innovata is

a leading source of world-wide airline schedules filed by airlines. Diio is a market intelligence source for the

aviation industry that is used to access the Innovata schedule data and other aviation data sources.

14 Initially, Southwest added 34 markets (Chart 5.2).

15 Case studies describing the events leading to the passage and subsequent repeal of the Wright Amendment

provision are “All You Need is Love: Southwest Airlines and the Wright Amendment (A) and (B),” authored by

The Darden Graduate School of Business, University of Virginia.

10

competition is a powerful driver as well, especially when potential entrants to an O&D city-pair

are strong companies with powerful capabilities.

Over the past almost-forty years, the LCC’s, especially Southwest Airlines, became a

powerful competitive counterpoint to the exercise of market power by other airlines. Moreover,

the industry during most of that period was plagued by overcapacity, had high fixed costs, and

suffered frequent external shocks to supply and demand, creating many bankruptcies and mergers.

Legacy carriers responded to deregulation by reorganizing their route structures and fleets. In

recent times they have created large international gateway hubs (for the most part) to integrate

themselves with foreign flag alliance partners (see Section 4.3 below).

Southwest gained significant cost advantages over legacy competitors by utilizing low cost

airports in many regions.16 It also implemented the business model described in Section 2.0 below.

This was accomplished by experimenting with pricing that explored the lower regions of the

demand curves (lower price regions), counting on the price elasticity of demand to be very large,

which it was.

Add to those advantages the superior performance of Southwest in safety and reliability, a

strong brand, and a very strong balance sheet and consistent profitability. This produced a new

entrant into O&D city-pairs which was highly credible as a competitor and had many competitive

advantages. The likelihood of Southwest entry into less competitive O&D city-pairs meant that

incumbents had to price with Southwest in mind (and later, other LCC’s).

Besanko, et. al.17 offer the following assessment of the importance of economies of scope

in these markets:

“…economies of scope occur when a firm producing many products has a

lower average cost than a firm producing just a few products…it makes

economic sense to think about individual origin-destination pairs…as distinct

products. Viewed in this way, economies of scope exist if an airline’s average

cost is lower the more origin-destination pairs it serves…hub-and-spoke

networks give rise to economies of scope (based upon) the economics of

density…(which are) economies of scale along a given route.”

Southwest Airlines competed with absolute cost advantages, market premia for brand

recognition, and strong economies of scope. It was a (perhaps the) driver of competition where it

16 For example, Love Field in Dallas (not DFW); Midway in Chicago (not O’Hare); Houston Hobby (not Houston

Intercontinental); Providence, RI and Manchester, NH (long before entering Boston Logan); among others.

17 Besanko, Dranove, Shanley and Schaefer, Economics of Strategy, 7th Edition, Wiley, 2016.

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entered a market. It was powerful as well where it was only a potential entrant. From the period

1979 through 2008, Southwest grew significantly. Meanwhile the legacy carriers faced poor

performance and many faced financial distress. Mergers and acquisitions, along with bankruptcy

restructuring, were their path out of the crisis. What emerged was an industry focused on solving

excess capacity problems. This, of course, led to a more profitable industry after the Global

Financial Crisis, one that had a chance to finally achieve reasonable returns on investment.

Southwest and other LCC’s also faced a rosier industry structure in which to compete.

They, in contrast to the legacy carriers, had a robust low fare business model. Southwest also

acquired AirTran in 2011 and consolidated its market positions while expanding the scope of its

network still further. By this time, the Company’s success had produced a significant market share

to the point of becoming the largest carrier of domestic passengers. Having exploited its business

model successfully in a large number of O&D markets, this perhaps lessened the incremental effect

of further new entry with nonstop service. However, Southwest’s power as a potential entrant

continues to be strong, especially as the great economies of scope persist.

It was quite logical for average fares in markets to rise as market concentration increased

and overcapacity was greatly reduced after the Global Financial Crisis of 2007-2008. This was a

natural response to reduced capacity and to external shocks as well, such as the added security

costs post-9/11 and the spike in the price of oil to $147 per barrel. Because these industry effects

will impact average fares (increasing them, but with cost reductions working in the opposite

direction), it might be tempting to conclude that the LCC’s (and Southwest in particular) were less

effective at keeping fares low. That would reflect a poor understanding of the market.

The key point to understand is that the Southwest Effect (and the effect of other LCC’s) is

an incremental force. It is the comparison of what fares would be, versus what fares actually are,

that is relevant when Southwest is a persistent actual and potential entrant with significant

competitive advantages that are well known to the consumer. Average market fares will change

due to other factors as well, but they would be much higher and traffic would be much lower were

Southwest not a competitor in the relevant markets. That is the essence of the Southwest Effect.

Empirical evidence is offered below on the still formidable effects of Southwest as a

domestic competitor.

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2.0 CORE PRINCIPLES FOR SUCCESS

For any company, airline or nonairline, to record 44 consecutive years of significant growth

and profitability from 1973 through 2016 it had to be doing something right and executing

extremely well (Exhibit 1). Southwest’s strategy and business model which has stood the test of

time in a tumultuous competitive environment was conceived and built upon several essential

pillars: (1) positive culture, (2) operational efficiency, (3) product simplicity, (4) high frequency,

and (5) low fares.

Positive Culture

To understand the business model of Southwest is to understand its culture. No two

individuals had more impact on creating and perpetuating the positive culture than Herb Kelleher

and Colleen Barrett. They retired as Executive Chairman, and President respectively in 2008.

Southwest’s current senior management team led by Gary Kelly, Chairman and CEO, have

tirelessly encouraged and promoted continuation of the Southwest culture built over 46 years of

proven success.

The Southwest culture began with creating a work atmosphere that was fun, often playfully

spontaneous and exciting.18 Ms. Barrett was the original creator of the Southwest employee

personality which remains at the core of the Company’s culture today. The Company’s employees

were extroverts, team players, dedicated to their cause, loyal to each other and Southwest, and

placed high value on hard work and success. They wanted employees who thought creatively,

were risk takers, and who accepted responsibility for their decisions. Southwest’s employee

screening and selection process was designed to identify applicants with these personal attributes.

Southwest has long been rated as one of the best companies to work for in America,19 and from its

beginning it has stressed profit and ownership-sharing for the employees.

Southwest’s dedication to customer service exceeded the norms of other airlines in part

because the “Southwest employee” was naturally a consumer-centered individual. The same high

standards and expectations were reflected in Southwest’s extremely high ratings for safety and

18 See, for example, Nuts, op. cit., pages 146-155.

19 In February, 2017 Southwest was named by Fortune magazine as the eighth most admired company in the world.

It is the only airline to be ranked in the top 10. Southwest has been on Fortune’s list for the past 23 consecutive

years (Southwest Airlines website).

13

operational reliability, both of which were positive attributes in the mind of the consumer and the

employee.

Operational Efficiency

Southwest’s business model demanded exceptional operational efficiency in order to

achieve low unit costs. High market frequencies helped to stimulate traffic and gain maximum

productivity of the aircraft fleet as well as airport personnel, facilities, and equipment. The famous

“ten-minute turn” (when the planes were smaller), kept planes in the air earning revenue and not

sitting on the ground waiting for the next group of passengers to board. Southwest rejected the

hub and spoke network concept in part because the ground times required at hub locations were

too long. Southwest’s flight attendants, ramp crews, and gate agents were trained to achieve the

quick turn by having the airplane ready for boarding as soon as the last inbound passenger

disembarked. The Company’s decision not to provide seat assignment contributed to boarding

speed and efficiency.

Southwest has only flown one aircraft type its entire life: the B737.20 Operating just one

basic aircraft type allows the Company great efficiency. Crew training has been limited to one

aircraft type. This has also helped to maximize crew utilization. Maintenance training and spare

parts inventories have been minimized. Negotiating leverage with suppliers has been maximized.

Ground equipment has been standardized to minimize system requirements.

Product Simplicity

Southwest’s configuration is all-coach in every airplane. It has never operated with a

premium section (business or first class).21 The in-flight service has always been simple-snacks

(peanuts) and beverages at no charge to the passenger. Booking reservations was designed to be

simple for the customer because it was only done through Southwest (currently only on

Southwest.com), and this has saved expense for Southwest and cost for the passenger because they

pay little or no fees and commissions to intermediary booking or distribution companies.

In the current environment where other airlines charge the customer for checked baggage

and cancelled or changed reservations, Southwest does not assess for these services. Some carriers

20 After the merger with AirTran, Southwest operated the former’s B717 fleet for a short period until it disposed of

all units to Delta.

21 Among other benefits, this reduced the number of flight attendants per airplane for a given seat capacity.

14

charge for other ancillary services and in-flight snacks as well, in addition to baggage and

cancellation fees, but Southwest does not.22

So the Southwest product is simple, easy to convey to the customer, and the product

differences with other airlines are pronounced and easily remembered.

High Frequency

In the beginning, and for many years thereafter, Southwest’s strategy for new market entry

was to commence service at a very high level of flight frequency. This was a way to shock the

market and announce Southwest’s new presence. In the current environment the new untapped

markets are much smaller because Southwest already serves 86 U.S. airports with 3,852 domestic

departures23 per day. So justification for entering a new market tends to dictate much lower

frequency today.

Low Fares

Southwest developed the model for achieving low unit costs through operational and

marketing efficiencies, employee productivity, and prudent financial stewardship. The resultant

low unit cost permits Southwest to offer low fares, certainly compared to the trunk line and local

service carriers during the early years, and compared to legacy carriers today.

Southwest’s business model centers on the use of low fares, in combination with high

frequency and reliable service, to stimulate travel demand. But, the primary driver of demand has

been low fares and low total trip cost for the passenger. Historically, Southwest set its fares based

on its cost of the flight with little regard to competing fares. It was always the Company’s objective

to divert travelers from cars, buses and trains to the airplane. In addition, it knew that with low

fares people would make more trips per year in the same or new markets (the velocity effect),24

and that travel groups would be larger (the group size effect).25

This low fare strategy worked extremely well for Southwest and for its customers. Chart

1.1 above shows that Southwest’s O&D traffic volume increased more than 10-fold from 1972

22 In recent years Southwest has instituted small fees for certain value-added services such as early boarding and pet

carriage.

23 As of July 2017 via Innovata schedule data. Including international airports, Southwest servers 101 airports with

3,962 daily departures.

24 For example, the college student going home six times in a school year instead of three; the sales person visiting a

key account once a month instead of once a quarter, etcetera.

25 For example, an entire family of four travelling to visit the grandparents, instead of just the mother and father; a

consulting or sales team taking junior members and not simply one or two seniors. The examples are numerous.

15

through 1978, and the number of Texas cities it served increased from 3 to 10 during the same

period. During this point in history, Southwest was restricted to serving only routes inside the

State of Texas. It was not dependent upon any passengers diverted from other airlines, but solely

on its own ability to generate new air trips that would not have occurred without its fares and

service. For the most part, Southwest created its own market and diverted relatively little from

other airlines.

Since competitive markets are dynamic and not static, it has almost always been a fact that

competing airlines have reacted to Southwest’s low fare initiative by reducing their own fares.

Sometimes they simply bracket the Southwest flights by reducing their fares only on flights just

before and just after a Southwest flight, and not for all their flights throughout the day. In other

instances competitors lower fares across the entire day and across multiple fare categories. The

competitors’ fare response is their strategy for maintaining passenger traffic levels and even

increasing traffic in some instances.

It is a well-known fact that, when Southwest lowers fares, traffic responds in a significant

way, and usually to a disproportionate degree. For example, Southwest may enter a market with

an average fare 25% below the prevailing average; incumbent carriers lower their fares by an

average of 15%; and total market traffic increases by 30% to 35%. In the sections that follow the

reader will see numerous examples of specific markets that have demonstrated this price elastic

response to Southwest.

Most domestic markets are price elastic and, over the past 46 years, Southwest Airlines has

been an empirical laboratory for demonstrating price elasticity in domestic air travel. This widely

understood phenomenon of Southwest entering markets with low fares and significant flight

frequency, causing a major traffic response, has been dubbed by the U.S. Department of

Transportation THE SOUTHWEST EFFECT.26 The DOT’s landmark study was published in

1993, but the Southwest Effect was actually born on June 18, 1971 when it began low fare service

with three B737’s providing twelve round trips per day between Dallas and Houston, and six daily

round trips between Dallas and San Antonio. From 1970 to 1974 the annual volume of O&D

26 Bennett, Randall D. and Craun, James M., The Airline Deregulation Evolution Continues: The Southwest Effect,

Office of Aviation Analysis, U.S. Department of Transportation, May 1993.

16

passengers more than doubled between Dallas and Houston, and the Dallas-San Antonio O&D

was over 2.5 times as great in 1974 as it was in 1970.27

27 Southwest Airlines 1975 Annual Report.

17

3.0 SUMMARY OF THE DOT FINDINGS AND OTHER MARKET EXAMPLES

3.1 Early Post-Deregulation

By May 1993 Southwest had been operating for 22 years, the last 14 of which were post-

deregulation. Except for limited interstate service at Love Field, Southwest was free to expand

across the United States. Southwest grew significantly post-deregulation, but it did so in a prudent

and well-planned manner. Because service reliability and maintenance of product standards were

vitally important, it did not stretch the organization or the operation too fast simply to achieve

growth for the sake of growth. Southwest had a sense that it could enter new markets almost

anytime with low fares, stimulate passenger volumes, and achieve a profitable load factor within

a few months. So it appeared to outside industry observers that network planning and expansion

was driven by financial prudence, operational integrity, and a vision of long term development

(what do I want to be when I grow up?).

Chart 3.1 below compares the Southwest route network at the time of deregulation (1978)

and in 1992 prior to the completion of the DOT’s study of the Southwest Effect.

18

Chart 3.1

Southwest Airlines Route Network

Source: Southwest Airlines, annual reports to the shareholders, and Innovata schedules via Diio.

While Southwest expanded between 1978 and 1992 by approximately 600% - 700%,

depending upon the metric, deregulation also touched off a wave of new start-up airlines, some of

which obtained CAB certification, completed their start-up financing, and actually flew. Notable

examples include Midway Airlines, PeopleExpress, New York Air, Muse Air and America West.

Many others did not begin flight operations at all. Almost every new entrant’s business plan was

premised on low cost, and fares much lower than the prevailing fares of trunk line and local service

December 1978

December 1992

OAK

SFO

SMF

CLE

STL

ONT

LBB

MAF

DTW

DET

MDW

MCI

AMA

OKC

HOU

AUS

SAT

CRP

HRL

SAN

BUR

LAX

ABQ

ELP

PHX

LAS

RNO

BHM

BNA

CMH

DAL

IAH

IND

LIT

MSY

TUL

AMA

MAF

HRL

CRP

AUS

SAT

ELP

LBB

DAL

HOU

Cities

Wee

19

airlines. Low cost structures were aided by the ability to pay entry level wages to non-union

employees. Their founders generally wanted to copy the Southwest model, but they all varied

from it just enough to cause their own demise. None of the above-named airlines survived, and

none exist today as separate entities. The longest lasting new entrant was America West which

began operations in 1983, later went through Chapter 11 reorganization (1991 – 1994), and then

merged with US Airways in 2005. US Airways itself merged with American in 2013. New entrant

low fare carriers simply could not stick to their knitting.28

Since deregulation in 1978 scores of new entrant airlines have been founded, planned, and

abandoned or met failure! Southwest Airlines is a pre-deregulation intrastate carrier and a post-

deregulation interstate airline. Of all the new interstate airlines formed after deregulation,

Southwest is the only one from the 1978-1993 era still operating as a stand-alone carrier.

3.2 The DOT’s Study of the Southwest Effect

In May, 1993 the DOT published its seminal study of the impacts created by Southwest’s

entry in markets dominated by legacy airlines. The DOT researchers used the California corridor

markets as their empirical study laboratory. In every case of direct entry by Southwest (OAK-

ONT, OAK-BUR and OAK-LAX) they found that for these markets (combined) market fares

declined by approximately 50% and total traffic more than tripled.29 In some instances the

incumbent carriers reduced their fares and added capacity; in other cases they exited the market.

The results of Southwest’s experience was dubbed by the DOT as “The Southwest Effect” and it

is stated in the DOT report that the Southwest Effect (in the California corridor) . . . “is a prime

example of how Southwest is changing the industry.”30 (Emphasis supplied).

The size and significance of the Southwest Effect soon became very apparent in scores of

markets across the country. The DOT study also discovered adjacent market effects in the Bay

Area. Southwest’s low fare services in three Oakland-Southern California markets had a material

impact on fares in the same Southern California markets to/from San Francisco (SFO), an airport

28 Some started with all-coach seating and later added business class. Some started with one airplane type but then

added other types to their fleet. Some started with one hub city, then added others too soon. Some expanded their

breadth of service (number of markets) before gaining strong positions in existing markets. The list of significant

deviations from the Southwest model could be expanded.

29 Ibid, page 6.

30 Ibid, page 5.

20

that Southwest did not then serve. So, the Southwest Effect was observed in both the direct

markets (Oakland) and in the indirect or adjacent markets (San Francisco).

At the time of the DOT study Dr. Campbell had occasion to evaluate and measure

empirically the Southwest Effect in many markets beyond California. His findings corroborated

the DOT results. A brief summary of Dr. Campbell’s analysis is presented in Chart 3.2 below with

data from both airports combined for simplicity where relevant.

Chart 3.2

Examples of the Southwest Effect in the Late 1990’s

Prior studies by Dr. Campbell also discovered significant adjacent market effects when

Southwest has entered one regional airport and impacted fares, service and traffic at other regional

or local airports. For example, after Southwest entered Chicago in 1985 using Midway Airport

and not O’Hare, the impact of Southwest’s low fares and service at Midway had a significant and

measurable effect on fares and passenger volumes at O’Hare.

Exhibit 2 presents a sample of Chicago market impacts where the Southwest Effect may

be observed clearly. This exhibit with 15 Chicago O&D markets demonstrates enormous adjacent

market effects; that is, the significant impact that Southwest’s Midway fares and service have had

on fares and resultant traffic at O’Hare. The Chicago experience is summarized in Chart 3.3 below

with data from both airports combined for simplicity.

Marke t Total Market

Ave rage Fare O&D Passenger

Market Paid Fare O&D Passengers Paid Fare

O&D Passengers

Decline Incre ase

BNA-DTW $155 242,360 $93 285,180 -40.0% 17.7%

Chicago-JAN $174 34,780 $105 81,180 -39.3% 133.4%

IND-MCO $107 267,950 $84 359,750

-21.8% 34.3%

CMH-BNA $132 28,880 $107 48,420

-18.8% 67.7%

IND-JAX $128 32,530 $100 49,560

-21.8% 52.4%

12 Month Period

Average Before Entry

Average After Entry

21

Chart 3.3

Examples of the Southwest Effect in Chicago Since 2002

Source: Exhibit 2.

The Southwest Effect continued to deliver significant consumer benefits as the airline

expanded across America throughout the 1990’s, the decade of the 2000’s, and since 2010 after its

merger with AirTran. Even Chapter 11 bankruptcy reorganization among all the legacy airlines,

which materially reduced their costs and lowered their fares, did not eliminate the consumer

benefits of Southwest’s low fares and traffic stimulation when it entered new nonstop markets.

As a fundamental Company strategy driving consumer behavior, the Southwest Effect has

endured consistently over the entire life cycle of the Company. Low cost carrier (“LCC”) and

ultra-low cost carrier (“ULCC”) competitors have come and gone since deregulation. Today,

several successful low fare airlines with defined market niches compete with Southwest in many

O&D markets. Nevertheless, the Southwest Effect delivers $9.1 billion worth of annual fare

savings, as shown in Section 7.0.

Market Total Market

O&D Average Fare O&D Passenger

Market Paid Fare O&D Passengers Paid Fare O&D Passengers Decline Increase

SAN $ 192 377,417

$ 137 532,312

-28.6% 41.0%

PHL $ 173 697,510

$ 97 1,006,489

-43.7% 44.3%

ORF $ 127 134,256 $ 122 162,303

-4.2% 20.9%

AUS $ 157 231,824

$ 146 297,648

-7.0% 28.4%

BUF $ 169 107,004

$ 98 220,509 -42.3% 106.1%

PIT $ 104 332,099 $ 73 496,243

-29.8% 49.4%

SJC $ 188 193,063

$ 174 274,811

-7.4% 42.3%

SAT $ 163 208,619

$ 124 327,138 -23.9% 56.8%

DEN $ 138 905,997

$ 125 1,098,026 -9.5% 21.2%

CHS $ 212 68,791

$ 172 137,308 -18.8% 99.6%

GSP $ 237 33,776 $ 154 112,001 -34.9% 231.6%

DSM $ 281 41,676

$ 152 94,205 -45.8% 126.0%

ICT $ 245 43,262

$ 172 80,837 -29.8% 86.9%

ROC $ 244 57,709 $ 163 114,597

-33.1% 98.6%

TUL $ 231 86,104

$ 193 102,053 -16.3% 18.5%

Chicago (MDW and ORD Combined)

12 Month Period

Average Before Entry

Average After Entry

22

4.0 THE SOUTHWEST EFFECT SINCE THE 1993 DOT REPORT

As Southwest Airlines continued to expand from its base as a short haul carrier, it added

new longer haul markets that were well suited to the Southwest product and fare structure. Since

new airlines, and LCC’s in particular, gain most of their economic advantage from cost elements

that are independent of length of haul, naturally the percent fare reduction diminishes as the length

of passenger trip increases. Key variable costs like fuel, aircraft ownership (including the cost of

money), maintenance, and passenger insurance tend to be roughly the same for all operators of a

given aircraft type. However, airport expenses, marketing and distribution, accounting and IT,

and many overhead costs vary per passenger, and not on a passenger-mile basis, for a given

passenger trip. In rate-making terms it is a difference between terminal and line-haul costs across

the carriers.

Another consideration is the fact that Southwest’s labor costs have naturally increased over

time as more seniority and longevity has accrued to its workers. Start-up airlines always have a

zero-seniority labor cost advantage initially, but this does not necessarily translate into a lower

total unit cost because a larger carrier like Southwest captures efficiencies and economies of scale

and scope that no small start-up or early stage airline can duplicate. Finally, all the legacy carrier

bankruptcies had the effect of reducing their unit costs and ultimately their fares in competitive

markets.

The significant factors mentioned above had the natural effect of reducing the percentage

difference between Southwest’s fares and legacy31 carrier fares when Southwest entered new

markets in recent years. However, the absolute dollar differences between Southwest’s new

market entry fares and the network carrier fares prior to Southwest’s entry has been maintained

and generally increases with passenger trip length (Chart 4.1). Southwest’s fare levels are

approximately 40% below network carrier fare levels where they face no low cost carrier

competition.

31 Legacy carriers included in this analysis are Delta, American and United.

23

Chart 4.1

Average One-Way Fare Levels of U.S. Legacy Carriers vs. Southwest32

(CY 2016)

Southwest causes legacy airlines to reduce their fares significantly, as shown throughout

this study. In fact, one-way fares in markets served by Southwest are on average $45 lower than

they would have been without Southwest nonstop service (see Chart 7.2).

4.1 Examples of the Southwest Effect during the 1993-2010 Time Frame

The DOT study33analyzed the Southwest Effect in several California corridor markets.

Section 3.0 provides analysis of other markets during the same time frame. The Southwest Effect

at Chicago Midway is a classic example of what the DOT study highlighted – lower fares and

significant traffic response at a particular airport, plus the adjacent market effect reflecting

competitive response at another regional or local airport, usually with positive traffic stimulation

32 Average per-passenger baggage and reservation cancellation fees paid are included in this chart. The individual

fare curves are determined by regression analysis of the U.S. DOT, Origin-Destination Passenger Survey data, via

Diio, CY 2016. Includes only nonstop markets.

33 DOT, op.cit.

$0

$20

$40

$60

$80

$100

$120

$140

$160

$180

$200

$220

$240

$260

$280

$300

$320

$340

$360

$380

$400

250 350 450 550 650 750 8 50 950 1050 1150 1250 1350 1450 1550 1650 1750 1850 1950 2050 2150 2250 2350 2450

American Without LCC Competition

Delta Without LCC C ompetition

United Without LCC Competition

Southwest

Average

One-Way Fares

Delta

American

Unite d

Southwest

Passenger Trip Length (miles)

24

at the adjacent airport assuming the competing airlines maintain or increase their capacity (Exhibit

2 and Chart 3.3).

In 1993 Southwest began operations at BWI, one of three airports in the

Washington/Baltimore region. Chart 4.2 below demonstrates the significant impact of the

Southwest Effect in several BWI city-pair markets.

Chart 4.2

The Southwest Effect in Selected BWI City-Pair Markets

In 2010 Southwest was serving 366 nonstop domestic markets which it did not serve in

1993. As may be observed in Chart 4.3 below, Southwest doubled in size and scope over the 1993-

2010 time period.

Market Total Market

Ave rage Fare O&D Passenger

Paid Fare O&D Passengers Paid Fare O&D Passengers Decline Incre ase

LIT $166 93,814 $129 97,970

-22.3% 4.4%

PBI $130 276,241 $116 300,746 -10.7% 8.9%

CMH $129 288,127

$88 306,528 -31.9% 6.4%

ORF $161 92,596

$83 98,083

-48.4% 5.9%

SJC $234 183,481 $199 218,153 -15.2% 18.9%

SAN $219 478,421

$211 538,536

-3.8% 12.6%

DTW $118 679,099

$79 953,733

-33.1% 40.4%

OKC $171 136,374

$185 159,850

7.7% 17.2%

CHS $212 145,772

$155 247,151

-26.9% 69.5%

GSP $171 54,947

$136 112,109 -20.4% 104.0%

FNT $154 9,422

$97 61,007 -36.8% 547.5%

Washington (BWI, IAD and DCA Combined)

12 Month Period

Average Before Entry

Average After Entry

25

Chart 4.3

Southwest Airlines Route System34

Source: Innovata schedules via Diio.

The Southwest Effect may be measured for any or all of the new Southwest markets, but

for purposes of this paper a selection of 10 markets varying in size, distance and competition

should suffice to make the point (Chart 4.4).

34 1993 derived from DOT T-100 reports for July 1993; and 2010 created from the flight schedule published by

Innovata, via Diio.

26

Chart 4.4

The Southwest Effect in a Sample of Other

Markets Entered Between 2000 and 2010

Chart 4.4 above shows that as a result of Southwest’s entry and low fares in 10 sample

markets, average market fares declined by 28.6% (Chicago-San Diego) to 68.8% (Philadelphia-

Raleigh/Durham), while traffic increased by 41.1% (Chicago-San Diego) to 322% (Baltimore-

Pittsburgh).

Chart 4.5 below displays graphically the magnitude of fare decline and traffic stimulation

for each market shown in Chart 4.4.

Market Total Marke t

Ave rage Fare

O&D Passenger

Market Paid Fare O&D Passengers Paid Fare O&D Passengers Decline Incre ase

DEN-ABQ $134 157,773 $79 243,405 -41.0% 54.3%

DEN-BNA $164 147,433 $117 228,729 -28.9% 55.1%

Chicago-BUF $169 107,004 $98 220,509 -42.3% 106.1%

Chicago-SAN

$192 377,417 $137 532,312 -28.6% 41.0%

BWI-PIT $172 27,102 $58 114,372 -66.4% 322.0%

MKE-MCI $156 73,076 $91 149,134 -41.4% 104.1%

PBI-TPA $104 56,348 $63 94,291 -39.9% 67.3%

PHL-RDU $171 171,657 $53 527,314 -68.8% 207.2%

12 Month Period

Average Before Entry

Average After Entry

27

Chart 4.5

Graphical Demonstration of the Southwest Effect in

Sample of Markets Entered Between 2000 and 2010

Southwest’s production of consumer benefits, as expressed by the Southwest Effect,

persisted in the 2000 to 2010 time period even though other low cost carriers like JetBlue and

Frontier entered new markets and stimulated traffic with their low fares. It is also true that the

bankruptcies of US Airways, America West, Delta, Northwest and United during this time period

did not eliminate or substantially reduce the magnitude of the Southwest Effect, even though the

legacy carriers emerged from bankruptcy with lower costs.

4.2 Demonstration of the Southwest Effect in Recent Times

As an airline expands to the point where it serves 89 domestic airports and is the largest

carrier of passengers in the U.S., its effects have become rather ubiquitous. This has been the case

for Southwest. As a result of its merger with AirTran in 2011, Southwest became a true nationwide

carrier, even though it was highly restricted in its service to certain markets due to airport slot

restrictions - like New York (LGA), and Washington (DCA) - and gate limitations – like Dallas

(DAL). Nevertheless, Southwest developed such a broad presence in the domestic air service

system that its fares frequently had impact on markets that it served only with one-stop

connections. So, when it came time to inaugurate nonstop service in these markets, some of the

-41.0% -28.9% -42.3% -28.6%

-66.4%

-41.4% -39.9%

-68.8%

54.3% 55.1%

106.1%

41.0%

104.1%

67.3%

207.2%

-100%

-50%

0%

50%

100%

150%

200%

250%

DEN-ABQ DEN-BNA Chicago-

BUF Chicago-

SAN BWI-PIT MKE-MCI PBI-TPA PHL-RDU

Market Average Fare Decline

Total Market O&D Passenger Increase

% Change

322.0%

350%

28

Southwest Effect had already occurred. Two examples of this phenomenon are discussed below.

In the case of Dallas-Phoenix, Southwest’s average connecting fare was already 17% below other

carriers in the market and Southwest captured 26% of the O&D traffic. After it inaugurated its

own nonstop service in September 2014 the average market fare declined by another 16% and

passenger volume increased by 21%.35

In the second example, Indianapolis- Los Angeles, Southwest’s average connecting fare

was 18% below the average of other competing carriers in the market, and Southwest’s O&D

market share was 20%. Then, in 2015, Southwest began nonstop service and the average market

fare declined by a further 12% while traffic increased by 26% (Exhibit 6).

From July, 2010 through July, 2017 Southwest increased the number of nonstop markets

served by 239. As shown in Chart 4.6 below, Southwest’s expansion was partly due to organic

growth and partly a result of its acquisition of AirTran in 2011.

35 From U.S. DOT, Origin-Destination Passenger Survey data, via Diio, and Exhibit 6.

29

Chart 4.6

Southwest Airlines Route System36

The Southwest Effect is observed to significant degrees in new markets entered during the

past six years. A sample of those markets and the measured Southwest Effect is presented in Chart

4.7 below.

36 From schedules published by Innovata, via Diio.

LIR

VRA

VRA SNU

SNU

HAV

SAT

SAT PNS

PNS

BUF

DCA

IAD

BDL

BDL PVD

PVD

MHT

LGA

EWR

SEA

PDX

SJC

SMF

SFO

SNA

LGB

BUR

LAX

SAN

SJD

PVR

PVR MEX

MEX

HRL

CRP

HOU

BZE

CUN

GCM

GCM PUJ

PUJ

RSW

TPA

ABQ

ALB

AMA

ATL

AUA

AUS

BHM

BNA

BOI

BOI BOS

BOS

BWI

CHS

CLE

CLT

CMH

CVG

DAL

DEN

DSM

DSM DTW

DTW

ECP

ELP

FLL

FNT

GEG

GRR

GSP

ICT

IND

IND ISP

ISP

JAX

LAS

LBB

LBB LIT

LIT

MAF

MBJ

MCI

MCO

MDW

MEM

MKE

MSP

MSY

NAS

OAK

OKC

OMA

ONT

ORF

PBI

PHL

PHX

PIT

PWM

RDU

RIC

RNO

ROC

SDF

SJO

SJU

SLC

STL

TUL

TUS

LGA

LAS

SNA

BUR

SJC

SMF

SEA

PDX

SFO

CRP

SAT

SAN

LAX

TPA

RSW

IAD

JAN

ABQ

ALB

AMA

AUS

BDL

BHM

BNA

BOI

BOS

BUF

BWI

CLE

CMH

DAL

DEN

DTW

ECP

ELP

FLL

GEG

HOU

HRL

IND

ISP

JAX

LBB

LIT

MAF

MCI

MCO

MDW

MHT

MKE

MSP

MSY

OAK

OKC

OMA

ONT

ORF

PBI

PHL

PHX

PIT

PVD

RDU

RNO

SDF

SLC

STL

TUL

TUS

30

Chart 4.7

The Southwest Effect Has Been Profound in Recent Times

(2012-2015)

Source: Exhibit 6

The sample of markets measuring the recent Southwest Effect in Chart 4.7 above is

presented graphically in Chart 4.8 below. The profound consumer response (traffic increase) to

Southwest’s low fare initiatives in newly served markets is visually apparent.

Market Total Market

Ave rage Fare

O&D Passenger

Market Paid Fare O&D Passengers Paid Fare O&D Passengers Decline Increase

BNA-PNS $224 7,442 $123 47,821 -45.3% 542.6%

Chicago-ICT $245 43,262 $172 80,837 -29.8% 86.9%

Chicago-MEM $248 110,492 $175 176,593 -29.5% 59.8%

Chicago-PNS $203 58,855 $187 66,547 -7.8% 13.1%

Houston-MEM $214 58,043 $178 110,971 -16.9% 91.2%

LAS-FNT $212 11,082 $165 62,538 -22.5% 464.3%

MSY-AUS $196 70,105 $170 102,755 -13.1% 46.6%

MSY-SAN $255 71,743 $217 101,422 -14.9% 41.4%

STL-GRR $190 11,973 $129 23,748 -32.1% 98.3%

TPA-MEM $178 61,559 $149 84,408 -16.5% 37.1%

12 Month Period

Average Before Entry

Average After Entry

31

Chart 4.8

Graphical Representation of the Southwest Effect in Recent Times

(2012-2015)

Source: Exhibit 6

Consumers in these markets and scores of others have received significant fare savings and

have been able to travel by air more frequently. The authors have seen no empirical evidence to

suggest that the Southwest Effect has diminished in relative37 impact. For all 109 new Southwest

nonstop markets analyzed in Exhibit 6, the weighted average market fare reduction was 15% and

the corresponding traffic increase was 28% (Chart 6.4). The fact that new markets are typically

smaller38 and had already enjoyed Southwest’s fare impacts when they were served as one-stop

markets explains the reduction in calculated Southwest Effect.

4.3 Significant Restructuring by the Legacy Airlines

During the past 25 years there has been a sustained and aggressive drive toward

globalization in the airline industry. This has been facilitated by the U.S. Government’s leadership

in negotiating and securing open skies agreements with 120 other nations39, including most of our

largest trading partners.

37 Relative to market size and pre-entry fare levels.

38 New markets entered at DAL, DCA and LGA were not small but many had already enjoyed Southwest’s low fare

connecting service over a period of many years.

39 https://www.state.gov/e/eb/rls/fs/2017/267131.htm.

-45.3%

-29.8% -29.5%

-7.8% -16.9% -22.5%

-13.1% -14.9%

-32.1%

-16.5%

86.9%

59.8%

13.1%

91.2%

16.6%

41.4%

98.3%

37.1%

-50%

-30%

-10%

10%

30%

50%

70%

90%

110%

130%

150%

BNA-PNS Chicago-

ICT Chicago-

MEM Chicago-

PNS Houston-

MEM LAS-FNT MSY-AUS MSY-SAN STL-GRR TPA-MEM

Market Average Fare Decline

Total Market O&D Passenger Increase

% Change

542.6% 464.3%

550%

32

One significant result of globalization has been the creation of three mega alliances

comprised of most of the major airlines of the world. As the U.S. legacy industry shrank by

bankruptcy and merger into three surviving airlines, each one became a member of one of three

global alliances.40 To leverage their alliance opportunities, and thereby maximize growth as

international carriers, the three U.S. legacy airlines reorganized their domestic networks to feed

their hubs, almost all of which serve as international connecting gateways. Nearly all of the purely

domestic legacy hubs have been eliminated.41

Today, 95% of all legacy carrier domestic flights depart or arrive at one of their hubs.42

This network reorganization has strengthened the surviving hubs while opening many new

domestic nonstop markets to low cost carriers, like Southwest.43

One of the significant consequences of legacy network reorganization is that all the growth

in domestic airline capacity has been provided by the LCC and ULCC airlines since 2000. The

legacy carriers actually provide 25% less domestic seat mile capacity now than they did in the year

2000, or 16% less if the legacy capacity is combined with their regional carrier partners.44

40 OneWorld (American), SkyTeam (Delta), and the Star Alliance (United).

41 For example, San Jose, Nashville, Raleigh/Durham, St. Louis, DFW (by Delta), Cincinnati, Pittsburgh, Memphis,

and Cleveland, among others.

42 Exhibit 3.

43 It should be noted that Southwest is not a member of any alliance and has not publically expressed any interest in

joining one.

44 Exhibit 4.

33

5.0 A SPECIAL CASE: DALLAS MARKETS AND REPEAL OF

THE WRIGHT AMENDMENT

The history of the Wright Amendment and the restrictions it imposed on flight services

to/from Love Field are highlighted in Section 1.3 above. After repeal of the Wright Amendment

in October, 2014, Southwest became free to serve any domestic market nonstop from Love Field.

With this opportunity the Company began to add new nonstop markets immediately and to pare

back service in some shorter haul markets to partially fund the expansion. In addition, Southwest

acquired two Love Field gates from United, giving it a total of 18. By adding two gates, thinning

the existing schedule somewhat, and reorganizing operations to achieve an average of 10 round

trips per gate per day, Southwest was able to increase its mid-week departures from 118 per day

in September 2014 to 180 per day by August 2015.

The Southwest Airlines Dallas route network before and after repeal is shown in Chart 5.1

below.

34

Chart 5.1

Southwest Airlines

Dallas Love Field Route Network45

Chart 5.2 displays the 34 new Dallas routes inaugurated by Southwest after repeal.46

45 From schedules published by Innovata, via Diio.

46 Includes the initial 34 routes from DAL. As of the July 2017 schedule, Southwest is serving 40 new markets at

DAL. Only 34 routes are used in the analysis that follows because a full year of data was available for these routes.

DAL

HOU

AUS

SAT

MAF

LBB

ELP

ABQ

ABQ AMA

AMA

MCI

TUL

ICT

OKC

ATL

BHM

ELD

IAH

LIT

MSY

STL

AUS

TPA

BWI

SNA

BUR

LAX

SAN

LAS

SJC

OAK

SFO

SMF

SEA

PDX

SLC

PHX

ABQ

ELP

DAL

MAF

LBB

AMA

DEN

DCA

SAT

SAT HOU

HOU

MCI

TUL

OMA

OKC

ATL

BHM

BNA

BOS

CHS

CLT

CMH

DTW

ECP

FLL

IND

LGA

LIT

MCO

MDW

MEM

MKE

MSY

PHL

PIT

RDU

STL

35

Chart 5.2

Southwest Airlines Thirty-Four (34)

New Dallas Routes Inaugurated After Repeal

Southwest’s expansion at Love Field drove Dallas market fares down appreciably. The

weighted average market fare across all 34 new Southwest markets, and including all airlines at

both DFW and DAL, declined by 25% from the 12 months ended September 30, 2014 to the 12

months ended September 30, 2016, while Dallas O&D passengers increased by 37% (Chart 5.3).

The fare impact and traffic response for each of the 34 markets is shown in Exhibit 5.

36

Chart 5.3

Southwest’s Expansion at Love Field Reduced

The Weighted Average Dallas Fare by 25%47

Base Period is YE Q3 2014. Current period is YE Q3 2016 (latest available).

Source: U.S. DOT, Origin-Destination Passenger Survey, via Diio.

The number of Dallas O&D passengers in the 34 new DAL markets (combined) increased

by over 5.0 million per year (Exhibit 5), and the annual fare savings earned by Dallas passengers

(inbound and outbound) totaled $920 million over the same time period (Chart 5.4).

47 Weighted average of DFW plus DAL fares by all carriers in Southwest’s 34 new DAL markets.

-25%

37%

(30.0%)

(20.0%)

(10.0%)

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

% Change

Decrease in

Market Fares Increase in Market

Passengers

37

Chart 5.4

Southwest’s Expansion at Love Field Has Produced

$920 Million in Annual Fare Savings for Dallas Passengers

Base Period is YE Q3 2014. Current period is YE Q3 2016 (latest available).

Source: U.S. DOT, Origin-Destination Passenger Survey, via Diio.

It is reasonable to conclude that the Southwest Effect, unleashed by repeal of the Wright

Amendment, is delivering close to $1 billion in consumer benefits annually to Dallas travelers and

a multiple of this in economic impacts for the North Texas economy and the 34 economies in

outside cities that now benefit from Southwest’s low fare service to and from Love Field.

Moreover, over five million more O&D passengers are using the two Dallas airports. The

significance of this for the traveling public can hardly be overstated: there has been nothing that

approaches this level of generating new passengers and consumer fare savings from a single

commercial airport in the history of the airline industry.

$0

$100

$200

$300

$400

$500

$600

$700

$800

$900

$1,000

DAL/DFW

Fare Savings

(Millions)

Savings to

Newly Generated

Passengers

(Stimulation)

$920 Million

$169 Million

$751 Million Savings to

Existing Passengers

38

6.0 COMPREHENSIVE ANALYSIS OF RECENT MARKETS ENTERED BY

SOUTHWEST AND CHANGE IN MARKET FARES AND PASSENGERS

This section of the report examines 109 nonstop markets entered by Southwest Airlines

between 2012 and 2015.48 The analysis demonstrates the changes in average market fare and

traffic (O&D passengers) after entry by Southwest. The 109 markets span all regions of the United

States (Chart 6.1).

Chart 6.1

Domestic Markets Entered by Southwest from 2012 Through 2015

As illustrated in Chart 6.2 below, 90% of nonstop markets entered by Southwest since 2012

experienced fare declines after its entry. Fifty-six (51%) experienced average fare declines in

excess of 15%, and 74 markets (68%) had average fare declines in excess of 10%. Of the 12

48 2015 is used as the most recent entry period because the latest DOT traffic data available at the time of analysis

was for the 12 months ending September 2016. The source for the data is the U.S. DOT, Origin-Destination

Passenger Survey, via Diio. The 109 markets include all domestic markets entered by Southwest with daily

nonstop service that were not also entered by other low cost carriers during the same period. The markets entered

by other low cost carriers were eliminated to isolate the Southwest Effect.

39

markets with fare increases, the majority already had low fares and/or connecting service on

Southwest before Southwest entered on a nonstop basis.

Chart 6.2

Distribution of Average Fare Change after Southwest Entry (2012-2015)

Chart 6.3 below shows the distribution of market passenger increases (all airlines) in these

same 109 markets. The most common category (23 markets) experienced a passenger increase of

20% to 30%. Eighty-nine percent (89%) of all markets experienced an increase in passengers of

10% or more and 72% experienced an increase of 20% or more. Ten of the 109 markets increased

by over 100%.

1212

6

8

13

23

18

15

8

3

9

0

5

10

15

20

25

-60% to

-55% -50% to

-45% -45% to -

40% -40% to

-35% -35% to

-30% -30% to

-25% -25% to -

20% -20% to

-15% -15% to

-10% -10% to

-5% -5% to

0% 0% to

5% >5%

Number of

Markets

Average Market Fare Change After Southwest Entry (%)

40

Chart 6.3

Distribution of Passenger Increase after Southwest Entry (2012-2015)

The median fare change in the 109 markets was a decline of 15%. The median passenger

increase was 30%. The weighted average (by passengers) produces similar results –a 15% fare

decline and a corresponding 28% passenger increase (Chart 6.4). A table with results by specific

market is provided in Exhibit 6.

Chart 6.4

Summary of Passenger Increase and Fare Change in 109 Recent

Southwest New Entry Markets (2012-2015)

Fare

Change

Passenger

Change

Median

-15.1%

30.1%

Weighted Average

-15.2%

27.8%

Source: Exhibit 6.

4

8

19

23

17

9

43

5

34

10

0

5

10

15

20

25

<0% 0% to 10% 10% to 20% 20% to 30% 30% to 40 % 40% to 50% 50% to 60% 60% to 70% 70% to 80% 80% to 90% 90% to 100% >100%

Number of

Markets

Average Market Passenger Volume Increase After Southwest Entry (%)

41

It is important to note that these findings are consistent with the model results discussed in

section 7.0 since they represent a mix of markets with, and without, Southwest connecting service

before Southwest began nonstop service.

42

7.0 FARE IMPACT MODEL AND THE SOUTHWEST EFFECT

The Southwest Effect has been explained and measured empirically by reference to many

markets entered by Southwest over the past four decades. It has been shown that Southwest has

delivered enormous consumer benefits in terms of fare savings and new nonstop service

convenience. In fact, our market analyses, beginning in the 1970’s and continuing to the present,

demonstrate quite consistently that the price elasticity effect of Southwest is greater than unity;

that is, the demand response is disproportionately greater than the amount of price reduction. For

example, a 20% fare reduction by Southwest produces on average a 35%-40% increase in

passengers. These findings demonstrate clearly that the same Southwest Effect measured and

described by the DOT in 1993 is very much alive and well today. Before leaving this topic, it is

important to measure the fare savings effects across the domestic network of markets.

In order to measure the effect of Southwest competition on fares in the domestic

marketplace, a multi-variate regression model was created. To isolate Southwest’s fare effect the

model controls for the impact of other low cost carriers, legacy carriers, distance, income, and

whether a market is primarily a leisure or business market. The model includes 24,375 markets

which account for over 99% of all domestic O&D travel. The variables in the model are shown

below in Chart 7.1.49

49 All fare and passenger data are from the U.S. DOT, Origin-Destination Passenger Survey, via Diio. Checked

baggage and cancellation/rebooking fee data is derived from U.S. DOT, Form 41. In addition, the convenience fees

of carriers that charge them are included. The source for convenience fees is carrier websites. The O&D passenger

volumes in this analysis include markets within the continental U.S. in order to eliminate interference created by

unique markets in Alaska and Hawaii, neither of which are served by Southwest. Markets in this model are defined

at the metro-level (grouping all airports within a metro area), and markets are weighted by the size of their O&D.

43

Chart 7.1

Regression Model with Market Average Fare as the Dependent Variable50

(CY 2016)

The model results are displayed below in Chart 7.2.51

50 The model distinguishes between nonstop and connecting service only for Southwest and JetBlue because these

airlines carry a significant number of passengers via connecting service. The other low cost carriers focus primarily

on point-to-point nonstop passengers.

51 The coefficients in the model are all statistically significant at the 99% confidence level..

Dependent Variable = Average Mark et Fare Market Fare including baggage, cancellation, and convenience fees paid by fare passengers

Independent Variables

LN (Dis tance) The natural log of distance for the market in miles

Geometric Mean of Income (Both Ends of O&D Market) Geometric mean of household income for an O&D market from 2016 Woods and Poole data

WN_NS A Dummy Variable Indicating if Southwest Has Nonstop Service

WN_CNX A Dummy Variable Indicating if Southwest Has a 5% or greater passenger share but does not have nonstop service

B6_NS A Dummy Variable Indicating if JetBlue Has Nonstop Service

B6_CNX A Dummy Variable Indicating if JetBlue Has a 5% or greater pass enger share but does not have nonstop service

F9 A Dummy Variable Indicating if Frontier has a 5% or greater passenger s hare

G4 A Dummy Variab le Indicating if Allegiant has a 5% or greater passeng er share

NK A Dummy Variable Indicating if Spirit has a 5% or greater passenger s hare

VX A Dummy Variab le Indicating if Virgin America has a 5% or greater passenger sh are

LEI S URE A Dummy Variable Indicating if the market touches Florida or Nevada

LEGACY_NS_CARRIERS Number of Legacy Carriers with nonstop s ervice in the market. Legacy carriers defin ed as Delta, United, American and Alaska

44

Chart 7.2

Regression Results

(CY 2016)

The model results indicate that one-way market average fares are $45 lower when

Southwest serves a market nonstop than when it does not, controlling for the other variables listed.

In fact, if Southwest provides only connecting service in a market, fares are $17 lower than they

are without Southwest’s competitive effect.52

52 It is important to note that the Campbell-Hill model is consistent with other econometric analyses such as the BLS

models developed by Jan Brueckner, Darin Lee and Ethan Singer. An update of this model by Compass Lexecon on

June 20, 2017 for Airlines 4 America entitled “An Assessment of Competition and Consumer Choice in Today’s

U.S. Airline Industry” at page 21 shows that Southwest nonstop competition reduces market average fares by 21%.

A natural log version of the Campbell-Hill model specified above also produces a 21% average fare decline with

Southwest nonstop service in a market.

Dependent Variable Total Market Average Fare (one-way)

N24,375

Multiple R 0.834

Squared Multiple R 0.696

Adjusted Squared Multiple R 0.696

Standard Error of Estimate 4,167

Independent Variables

Constant

-$157.74 3.05 0.0000

LN (Distance)

$51.57 0.39 0.0000

Geometric Mean of Income (Both Ends of the O&D Market)

$0.00049 0.00 0.0000

WN_NS

-$45.19 0.51 0.0000

WN_CNX

-$17.37 0.68 0.0000

B6_NS

-$25.71 0.62 0.0000

B6_CNX

-$17.08 2.81 0.0000

F9

-$15.89 0.59 0.0000

G4

-$59.03 0.91 0.0000

NK

-$33.46 0.53 0.0000

VX

-$2.45 0.77 0.0015

LEI S URE

-$14.40 0.57 0.0000

LEGACY_NS_CARRIERS

-$8.54 0.26 0.0000

Coefficient

Standard Error

p-Value

45

This model can be used to estimate the total overall impact on fares (consumer savings)

produced by Southwest. In order to do this, the per passenger fare impact was multiplied by O&D

passengers in each market where Southwest competes.53 Applying this analytical method, the

resulting estimate is that Southwest’s presence in markets reduces total domestic fares by $9.1

billion annually.

Southwest’s significant impact is driven both by its large fare savings per passenger and

by its significantly larger domestic network. Southwest carries at least 5% of the O&D passengers

in markets representing 70% of the total continental U.S. passengers (56% in nonstop markets and

14% in connecting markets).54

Southwest has the breadth of network to provide fare competition and consumer benefits

on a nationwide basis. For the years 2012 through 2015 Southwest’s fares offered in new nonstop

markets produced a 28% to 30% average traffic increase (Chart 6.4 and Exhibit 6). We find no

evidence that the Southwest Effect has been eroded or overtaken in significance or magnitude by

other airlines.

The empirical results in this section are obtained from a cross-section of markets based

upon O&D city-pairs. It is a static analysis intended to show the current incremental effect of

Southwest’s presence in a market along with that of other low cost competitors and legacy

carriers. This follows the tradition of a literature containing previous studies of the same type as

referred to in footnote 52.

In earlier sections above (3.0 through 6.0), we offer observations over time in average

domestic fares and passenger volumes and comparisons pre- and post-Southwest entry into

markets. While it would be desirable to have a combined cross-section and times series model to

combine insights, it would be unwieldy econometrically for many reasons. Instead we have

logically compatible observations that converge upon consistent insights about the size and

impact of the Southwest Effect across markets and over time.

53 In instances where more than one LCC competes, passengers were allocated by market share of the low cost

carriers.

54 Derived from the U.S. DOT Origin-Destination Passenger Survey for CY 2016. For purposes of this model the

5% minimum market share is used as a threshold to define an effective competitor.

46

In section 1.4, we also establish the logic that the Southwest Effect is, in reality, an

incremental effect. Therefore, changes in other factors that affect supply and demand for airline

service might, of course, also affect the observed fares and passenger volumes over time. For

example, a change in the presence and capacity offered by legacy carriers after facing severe

financial results and undertaking bankruptcy reorganizations and mergers could certainly affect

the level of competition and might very well result in higher fares in some markets. This would

likely be a healthy market response to difficult conditions because such competition was not

sustainable in a long-run equilibrium due to the financial losses at the previous equilibrium state.

Other examples of shifts in supply and demand conditions include fuel costs, higher security

costs post-9-11, and some loss of economies of scope by legacy carriers who shrank their

domestic capacity.

While the data presented on changes over time are not themselves incrementally

measured with other factors accounted for, the pre- and post-Southwest-Entry comparisons are

quite revealing. It is clear that, when added to the regression results in this section, the

incremental effect of Southwest Airlines is vigorous and ubiquitous. It bears testimony to the

empirical reality that the Southwest Effect explains major changes over time in the competitive

landscape.

47

EXHIBITS

48

Exhibit 1 (Page 1 of 2): Southwest Historical Financial Performance

(Operating Revenue-Billions)

49

Exhibit 1 (Page 2 of 2): Southwest Historical Financial Performance

(Net Income-Billions)

50

Exhibit 2: The Southwest Effect at Chicago Since 2002

51

Exhibit 3: Ninety-Five Percent (95%) of Legacy Carrier

Domestic Departures Are to/from Their Hubs

(July 2017)

52

Exhibit 4 (Page 1 of 2): Southwest Has Grown by 124% Since CY 2000 While

the Legacy Carriers Have Declined by 16% in the U.S. Domestic Market

53

Exhibit 4 (Page 2 of 2): Southwest Has Grown by 124% Since CY 2000 While

the Legacy Carriers Have Declined by 16% in the U.S. Domestic Market

54

Exhibit 5 (Page 1 of 3): Summary of Changes in DAL/DFW

Fares and Passengers after Wright Amendment Expiration

55

Exhibit 5 (Page 2 of 3): Summary of Changes in DAL/DFW

Fares and Passengers after Wright Amendment Expiration

56

Exhibit 5 (Page 3 of 3): Summary of Changes in DAL/DFW

Fares and Passengers after Wright Amendment Expiration

57

Exhibit 6 (Page 1 of 3): Nonstop Markets

Entered by Southwest from 2012-2015

58

Exhibit 6 (Page 2 of 3): Nonstop Markets

Entered by Southwest from 2012-2015

59

Exhibit 6 (Page 3 of 3): Nonstop Markets

Entered by Southwest from 2012-2015

Public Benefits and Private Success: The Southwest Effect Revisited

Abstract and Figures

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