Question : Who wins and who loses because of the new revenue-based FFPs? How will this affect the behaviour of United's customers?

Note :- ( Managerial Economics subject)

Read the case study below and answer the above question.

UNITED AIRLINES: FREQUENT FLYER PROGRAM

In June 2014, United Airlines, Inc. (United) announced that as of March 1, 2015, it would move from awarding miles based on distance flown to awarding miles for dollars spent for tickets, following in the footsteps of Delta Air Lines, which had recently made similar changes to its SkyMiles program. United's MileagePlus program president, Thomas O'Toole, said, "These changes are designed to more directly recognize the value of our members when they fly United.

In March 2015, many customers complained about United's new mileage policy and saw this change as a significant devaluation of award miles. According to the new mileage accrual plan, most United MileagePlus members would earn fewer miles unless they were flying on expensive short-haul flights or premium-class tickets (e.g., on business-class, first-class or full-fare economy-class tickets). Duane Myers, a Premier Gold member who flew more than 50,000 miles in 2014, said, "This is very disappointing. United already increased the redemption miles requirement recently. Based on my understanding of the new rule, flight miles earning has been devalued by about 50 per cent. Why do I need to pay more to get the same miles I used to get?"

INDUSTRY OVERVIEW

The U.S. airline industry was highly competitive and provided vital services. Domestically, United was competing with other major U.S. network carriers such as Delta Air Lines and American Airlines. At the same time, it was competing with low-cost carriers such as Southwest Airlines, JetBlue Airways, and Virgin America. Internationally, it was also competing against many other international airline companies such as Lufthansa, Air France-KLM, Japan Airlines, and Korean Air Lines.

The number of carriers had increased dramatically, and passenger revenue, airline traffic, and passenger- carrying capacity had also increased. Relatively stable industry concentration ratios except in the early 1980s, when deregulation allowed easy entry into the industry indicated that the largest airlines dominated the industry, whereas small airlines occupied only the niche markets (see Exhibit 1).

In 1978, the Airline Deregulation Act completely changed the structure of the industry. During the regulated period, airline companies could pass on any increased costs to consumers, using a fixed rate of return-based pricing. Deregulation removed almost all government control regarding entry into the industry, flight routes, and ticket prices. Due to the lowered entry barriers, there was a rush of new entrants into the industry. The number of carriers in the United States increased from 34 in 1978, to 106 in 1985 (see Exhibit 1). As a result, rates became highly competitive, the industry became less concentrated, and price wars became a common form of competition.

The high costs of aircraft and fuel were other challenges with which airlines needed to contend. Further, in order to run complex operations, airline companies had to maintain large labour forces, although they also had the ability to outsource some of their operations. In addition, due to excess capacity,³ no carriers had significant pricing power in the marketplace.

Every one of the major network carriers, including United, had previously filed for Chapter 11 bankruptcy protection (see Exhibit 2), and many of them had undergone mergers with other companies (see Exhibit 3). Delta Air Lines acquired Northwest Airlines in 2008, United merged with Continental Airlines in 2010, Southwest Airlines purchased AirTran Airways in 2011, and American Airlines and US Airways merged in 2013. As a result, these four airlines had come to control nearly 85 per cent of the domestic market.

Airline Alliance

As a mature Alliance with a comprehensive network and good, close relationships between our member airlines, we are excellently placed to offer continuous enhancements in various ways that together improve the Alliance travel experience.

A distinctive element in the airline industry was that most of the largest passenger airlines worldwide were members of one of three major alliances, often called global airline alliances Star Alliance, Oneworld, and SkyTeam (see Exhibit 4).⁶ Each alliance was composed of a number of airline companies that covered different geographical areas through larger networks. In 1997, the Star Alliance was founded, and competing airlines responded by forming Oneworld in 1999 and SkyTeam in 2000.

Alliances provided a network of connectivity, marketing branding, and convenience for international passengers and international packages. Airline alliances could extend their networks by code-sharing agreements,⁷ pricing cooperation, and coordination of schedules. Thus, customers could have improvedflexibility in terms of destinations and schedules. Also, these alliances reduced costs through the sharing of sales offices, maintenance facilities, airport lounges, and operating staff.

Customers earned award miles from flying on other alliance carriers and redeemed their miles by using award tickets from a single account. For example, United customers could earn miles by flying with other Star Alliance network carriers, such as Lufthansa and Air Canada. They could also redeem miles by getting free award tickets from these alliance partner carriers.

Frequent Flyer Program⁸

In addition to large network alliances, the airline industry had another unique characteristic namely, its frequent flyer programs (FFPs). An FFP was "a loyalty program offered by many airlines to customers allowing them to accumulate (or "earn") points for flights taken or services bought from the airlines' commercial partners."⁹

On May 1, 1981, following the industry deregulation in the United States, American Airlines launched the first FFP. The initial idea of the FFP was quite simple: rewarding high-frequency customers by giving them free tickets if they reached a certain threshold. FFPs could give customers incentives to use any single carrier repeatedly, thus increasing switching costs.

American Airlines initiated the next step of FFP development by introducing "gold" tiers into its program. Since then, other airlines had followed this model and offered special membership tiers (commonly referred to as elite programs, e.g., Silver, Gold, Platinum and 1K members for United) to recognize high-frequency customers. In addition, American Airlines initiated a joint marketing program with Hertz and Holland America Cruise. Airline companies realized that the miles could be used to generate external revenue by selling miles to their partners, such as hotels, and rental car and cruise companies. In order to determine the value of a mile, airlines used the equivalent commercial value of a reward ticket as a base.

In 1987, American Airlines and Citibank introduced the industry's first co-branded credit card, which was the most significant development in the history of FFPs. Frequent flyer co-branded credit cards delivered significant ancillary revenue for airline companies. By the early 1990s, most North American and European airlines had launched very similar types of FFPs, not only rewarding frequent flyers but also approaching less frequent flyers with alternative ways to earn miles.

Up until the early 1990s, airlines perceived FFPs as cost centres, especially given that customers' accrued miles were the liability of the companies. As FFPs matured, airlines realized the limitations of the early FFP models. As the number of alliance partners and program-participating customers increased, airlines had the problem of a limited inventory of award seats, which were originally intended to fill empty seats. Therefore, airlines increasingly put restrictions on reward tickets, used so-called "black-out" periods, and introduced mileage expiration policies. Customers felt that the reward seats were too limited, especially at the lowest reward level (e.g., 25,000 miles for a U.S. domestic flight).

The imbalance between accumulated miles and the availability of award seats created new challenges for FFPs. For example, at the end of 2007, Delta Air Lines' SkyMiles members had 510 billion unused miles in their accounts, United's MileagePlus had 488 billion unused miles, and American Airlines' AAdvantage Plan reported 613 billion unused miles. "We're at a turning point," said Jeff Robertson, managing director for Delta's SkyMiles program, explaining that although Delta Air Lines's members earned 27 per cent more miles in 2007 than in 2004, the capacity allocated for award seats stayed flat. "We at Delta [Air Lines] and as an industry cannot continue to have customers earn a significantly greater number of miles year after year without providing customers some flexibility in ways to use those miles."¹⁰

In order to address this imbalance, airlines began to make tactical changes to their programs. Many airlines adjusted the required miles for an award ticket, increasing capacity by simply devaluing the accumulated miles. For example, some airlines charged 40,000 miles for flights that used to be 30,000 miles. In simple terms, those "free" tickets for customers were about to get a lot more costly. Also, some airlines allowed customers to use their miles to book stays at hotels and resorts.

At the same time, some airlines had started to recognize dollars spent instead of distance flown. For example, members of JetBlue's FFP (TrueBlue program) earned three points for every dollar spent, and Virgin Australia offered its customers five points per dollar spent. Furthermore, Singapore Airlines had introduced its KrisFlyer top tier only to customers who spent more than S$25,000 (approximately US$19,500)¹¹ on first- or business-class tickets.

Once perceived as a reward program for frequent customers and a powerful marketing tool, FFPs had started to become businesses of their own. By selling miles to airlines' partners, an FFP could be a very attractive and cash-generating business, and airlines began to consider FFPs as separate business units. Therefore, even spin-offs of FFPs were considered. For instance, ACE Aviation Holdings (Air Canada's parent company) had sold 12.5 per cent of Aeroplan (Air Canada's FFP) through an initial public offering in 2005. From 2005 to 2008, ACE progressively sold its remaining stake, which made the Aeroplan Group into a pure loyalty management company. In May 2012, the company changed its name to Aimia Inc.

In sum, the airline industry had seen enormous potential in FFPs and changed its perspective on them (see Exhibit 5). Over a 30-year history, FFPs had evolved from simple customer reward programs to independent profit-generation business models.

COMPANY OVERVIEW

United Airlines

United Continental Holdings, Inc. was a holding company, and United Airlines, Inc. was its principal wholly owned subsidiary.United, with approximately 84,000 employees, had 373 destinations in 60 countries and served 138 million passengers in 2014. Its main hub cities included Chicago, Denver, Houston, Los Angeles, Newark, San Francisco, Washington, Guam, and Tokyo.United was a member of the Star Alliance, and the network carriers served over 1,300 airports in more than 190 countries, as of January 2015.

United operated 1,257 aircraft as of December 31, 2014. The company's financial forecast was promising: in 2015, Jeff Smisek, United's chief executive officer, announced a first-quarter profit of $508 million, compared with a $609 million loss in the same quarter of the previous year (see Exhibit 6) due to low jet- fuel costs and continued efforts at cost reduction. Industry analyst Jim Corridore rated United a "strong buy." He expected United to continue to generate revenue and lower debt: "We think the revenue environment remains good, and we remain positive on the company and the industry.

While the merger with Continental Airlines in October 2010 had made United one of the largest airlines in the world, the company still struggled to successfully merge two companies into one. At the time of the merger, executives expected the integration process to be wrapped up within 12 to 18 months. However, some of the integration work remained unfinished, including ongoing system integration and resolving relations with employees. For example, United had not yet finalized a unified labour contract with flight attendants, and mechanics were using two separate information technology systems for maintenance. Smisek said, "We're examining everything, because we have a set of assets that are very good. [But] they have not been producing the level of revenue they should be producing. We are keenly aware of that.

United's MileagePlus Program

United's FFP was its MileagePlus program aimed at building customer loyalty by offering awards and services to loyal customers. Before March 2015, the basic structure of the MileagePlus program was not significantly different from that of other major FFPs. The program had co-branded credit card marketing with Chase Bank USA, National Association, thus allowing customers to earn miles by using that credit card. Customers could also earn miles on qualifying cruise vacations and car rentals, as well as on shopping and dining at partner businesses. Miles expired after 18 months of member account inactivity.

The MileagePlus program generated a substantial amount of revenue (see Exhibit 7). Approximately 4.8 million, 5.0 million and 4.7 million MileagePlus flight awards miles were used in 2014, 2013, and 2012, respectively. These awards represented 7.1 per cent, 7.7 per cent, and 7.1 per cent of United's total revenue passenger miles¹⁸ in 2014, 2013, and 2012, respectively.

What's New in FFPs in 2015?

On June 10, 2014, United confirmed that starting in March 2015, it would be moving to a revenue-based FFP. Under the new MileagePlus program, customers would not be awarded miles based on the distance (i.e., miles) flown, but rather, on how much they spent per flight (as explained below).¹⁹ The fare for mileage accrual included the base fare of the ticket plus carrier-imposed surcharges, but excluded any government- imposed taxes and surcharges.

• General MileagePlus members (non-elites): Earn five miles per dollar spent
• MileagePlus Premier Silver members: Earn seven miles per dollar spent
• MileagePlus Premier Gold members: Earn eight miles per dollar spent
• MileagePlus Premier Platinum members: Earn nine miles per dollar spent
• MileagePlus Premier 1K members: Earn 11 miles per dollar spent²⁰

The most common complaint about this change was that a passenger would earn fewer miles for flying the same flight. For instance, in the case of a $450 economy-class flight between Los Angeles and New York/Newark (with a one-way distance of 2,454 miles), customers at all levels would earn fewer miles under the new program, as shown in the following table. This change indicated that awards tickets would become more costly for all levels of passengers.

Non-elite

Silver

Gold

Platinum

1K

Previous program

4,908

6,135

7,362

8,589

9,816

New program

2,250

3,150

3,600

4,050

4,950

Also, there was frustration for those who were searching for a good bargain price, for example, for a trip to Frankfurt, Germany, from Chicago, United States, in which the customer would be rewarded the same miles as other customers who paid a very high price for a last-minute flight to San Francisco.

The new rules had caused other controversies. First, if passengers travelled on a ticket issued by United's alliance partners (e.g., Star Alliance carriers, such as Lufthansa and Air Canada), customers would accrue United miles based on distance flown, not how much they paid.

Second, there were no changes for the amount of miles earned by third-party partners, such as credit card companies. Thus, the net effect was to make miles earned from third parties more valuable than flying with airlines. Customers expressed their disappointment and anger on United's Facebook page. In particular, many customers were not happy about the massive devaluation (i.e., requiring more miles for free award tickets or seat upgrades) in February 2014.

WHAT'S NEXT?

The idea of a revenue-based FFP was quite simple: the more you spent, the more miles you would earn. However, this simple idea had potentially huge consequences for both customers and airlines.

Delta Air Lines and United had adopted revenue-based FFPs. The change was good for passengers who spent a considerable amount on tickets, sat in first- or business-class, and/or flew short distances with last- minute bookings. However, for most general customers, the change most likely meant a reduction in value earned from the program.

Among the largest U.S. carriers, American Airlines, one of the Oneworld carriers, was the only airline still using the conventional miles-based FFP. Should American Airlines also adopt the revenue-based FFP, following its competitors? The company could opt to keep its miles-based FFP, signalling that it valued all its customers, not just those who spent more. Alternatively, American Airlines could follow this trend once it finalized the American Airlines and US Airways post-merger integration.