The Mother of All (Pricing) Battles": The 1992 Airline Price War In the summer of 1992 the U.S. airline industry experienced one of the most brutal price wars any industry had ever experienced. This fare war deepened the already-record losses the airline industry was suffering in the wake of the recession that began with the Persian Gulf crisis in 1990. The airline industry is, of course, prone to price wars. However, in terms of the number of markets affected, the scale of the 1992 price war was extraordinary, even by the brutally competitive standards of the U.S. airline industry. Airline scholars Steven Morrison and Clifford Winston estimated that the reduction in overall industry profits in 1992 solely due to fare wars was $1.53 billion.1 The opening salvo in the 1992 fare war was launched on May 26, when Northwest Airlines initiated a promotion titled "Grown-Ups With Kids Fly Free." American Airlines responded the next day with an unprecedented fare sale: a 50 percent price cut on every seat on every route in its system. The sale, which was to last through June 5, covered all flights through September 13, and within 24 hours all major airlines had matched American's cuts. It was, in the words of one industry observer, "an electronic passenger riotthe telecommunications equivalent of shoppers tearing through soft goods in a sales bin."2 So eager were U.S. consumers to buy bargain airline tickets that at the height of the fare sale, AT&T experienced its single largest daily volume of long-distance phone traffic.3 Consumers who were unable to get through to the airlines or travel agents by phone drove to airports to buy tickets in person. Within days, every major airline's inventory of seats for the entire period was sold out. In the wake of these fare cuts, Northwest put out a statement deriding American's response. "American's action," a spokesperson for Northwest said, "is like nuclear warfare in response to a firecracker." American countered, "We were merely responding to Northwest. We have said over and over again that when other competitors undercut us, we will be competitive."

1 Steven Morrison and Clifford Winston, "Causes and Consequences of Airline Fare Wars," Brookings Papers: Microeconomics (1996): 85-123. 2 Thomas Petzinger, Hard Landing: The Epic Contest for Power and Profits That Plunged the Airlines Into Chaos (New York: Times Business, 1995), 410. 3 Petzinger, 410. THE 1992 AIRLINE PRICE WAR 5-204-250 2 KELLOGG SCHOOL OF MANAGEMENT Airline Pricing Airfares are constantly in flux. Consequently, the airlines make extensive use of information technology to store pricing information and communicate it to parties such as travel agents who need up-to-date prices. All major airlines post their fares in advance through a clearinghouse computer system run by the Airline Tariff Publishing Company (ATP), a venture jointly owned by the major airlines. The pricing departments of airlines use the ATP system to monitor closely competitors' prices. Indeed, in the early 1990s some industry observers alleged that airlines were using the ATP system to signal their pricing intentions to each other.4 American's Value Pricing Plan By 1992, the number of different fares offered by the major airlines was enormous. For each city pair served, an airline would set a first-class fare, a full coach fare, and a wide variety of discount fares, each with its own special set of restrictions. In fact, discount fares accounted for 95 percent of all traffic by 1991. In the spring of 1992, American Airlines commissioned an internal study to identify why the growth in air travel, which had boomed through the 1980s, had suddenly dropped in the early 1990s. One finding was that the growing complexity of airline fare structuresa complexity that American more than anyone had created through its pioneering of yield managementwas turning off consumers. In fact, air travelers were growing more and more to appreciate the transparent connection between value and price that characterized "Everyday Low Prices" touted by successful retailers such as Wal-Mart. In response to the study, on April 9, 1992, Robert Crandall, CEO of American Airlines, introduced a simplified pricing structure called Value Pricing. Crandall's plan, introduced at the largest press conference American Airlines had ever held and covered as a front page story in the New York Times, involved substantial drops in full coach, business class, and first-class fares while it also eliminated most discounts and standardized the fare structure. In particular, American dropped its full coach fares to the level of most prevailing discount fares. Finally, according to Crandall, never again would American Airlines offer a discount fare that fell more than 50 percent below the full coach price. Anatomy of a Price War American's announcement on April 9 took the rest of the industry by surprise. Still, within days, nearly all major airlines matched American's fare structure. Indeed, in an attempt to air advertisements rolling out its own version of Value Pricing, United Airlines was forced to find a substitute for its usual voice-over announcer, Gene Hackman.

4 This allegation led to a formal inquiry by the Department of Justice. Rather than contesting the case in the courts, all major airlines (except Southwest) entered into an out-of-court settlement with the U.S. government under which the airlines agreed to award discount flight coupons to passengers who had flown during the time period in which the airlines' pricing practices were thought to have led to overcharges. 5-204-250 THE 1992 AIRLINE PRICE WAR KELLOGG SCHOOL OF MANAGEMENT 3 Two airlines did not move in unison with American: TWA and USAir.5 TWA, at the time in bankruptcy, announced deeper price cuts than American's, while USAir announced deeper cuts on selected Florida routes. American's response was swift and surgical. In 1,500 markets where it competed head-to-head with TWA with comparable service, American dropped its fares to match TWA's. In markets where its service was not comparable, American reduced its fares but did not match TWA's. At the same time, American announced that it was matching USAir's fares in 300 markets where it competed head-to-head with USAir. According to Michael Gunn, American's vice president of marketing, "We made it clear that we will be competitive." On April 29, TWA lowered fares again in selected markets where it competed with American, and once more American immediately matched these fares. About a week later, on May 7, American announced that when TWA's promotion expired, it intended to raise fares by 10 to 25 percent in the 1,500 markets where it earlier had matched TWA. Other airlines matched American's move. A spokesperson for TWA announced its intention to study the proposal, while Michael Gunn of American reiterated, "We will remain competitive." On May 21, 1992, TWA allowed its discount fares in the 1,500 markets to lapse. Less than a week later, on May 26, while Bob Crandall of American was working out on his treadmill, an announcement of a limited-time promotion by Northwest Airlines appeared on the morning news. At one time, Northwest had been one of the industry's best managed and most profitable airlines. However, its acquisition of Republic Airlines in the mid-1980s had been expensive (costing $1 billion), and difficulties integrating Republic's workforce and administrative systems had led to noticeable deterioration in Northwest's service. (Among business travelers the airline had become known as "Northworst.") Saddled with an aging fleet and striving to make do with an oddly configured route structure that connected fewer cities and had fewer transcontinental flights than the Big Three, in the spring of 1992 Northwest was clearly struggling. Northwest's promotion, "Grown-Ups with Kids Fly Free," which applied to many, though not all, of its flights, in effect offered many vacation travelers a 50 percent price cut. Crandall's reaction"Son of a bitch!"summarized his disdain for this kind of gimmicky fare promotion that he had hoped his Value Pricing plan would wipe out. Throughout the day, industry insiders and observers awaited American's response: Would Crandall match Northwest's limited promotion, forcing American into creating a new fare categorysomething it vowed not to do seven weeks before when the Value Pricing plan was announced? Or would it, as some observers were speculating, "go nuclear" and cut prices across the board? The answer was forthcoming within 24 hours: American announced a 50 percent price cut on every seat on every route for flights through September 13, provided tickets were bought by June 5. All major airlines matched American's cuts, and within days, every major airline's inventory of seats for the entire period was sold out.

5 Southwest Airlines also did not match American's fares. However, in 1992 American Airlines (along with other major trunk carriers) viewed Southwest as a different "breed of animal," and throughout 1992 American generally did not retaliate when Southwest undercut its Value Pricing fares

Q1. Refer to the following excerpt in the case: In the wake of these fare cuts, Northwest put out a statement deriding American's response. "American's action," a spokesperson for Northwest said, "is like nuclear warfare in response to a firecracker." American countered, "We were merely responding to Northwest. We have said over and over again that when other competitors undercut us, we will be competitive." (a) Elucidate the critical characteristics of the market structure for the U.S. airlines industry. (b) What has been done in the U.S. airlines industry to ensure price competitiveness among the major airline players? How could price signalling benefit this industry? Q2. Explain clearly the different pricing strategies adopted by players in the U.S. airlines industry. How do competitors strategize and respond to value-based and discounted pricing by American Airlines? [15 marks] Q3. Refer to the following excerpt in the case: "American announced a 50 percent price cut on every seat on every route for flights through September 13, provided tickets were bought by June 5. All major airlines matched American's cuts, and within days, every major airline's inventory of seats for the entire period was sold out." a) As an industry analyst, critically comment on the decision taken by the American Airlines in response to Northwest's limited promotion offer that provided the vacation travellers a 50 percent price cut. Justify your comment in light of the U.S. airlines Industry's health.