Why are airlines in the US offering $13 cross-country airfares?

We have moved all teaching online, and my (now fully online) ECONS101 class is marching ahead. The last couple of weeks we have been covering the behaviour of firms with market power (that is, firms that have the power to set their own price). Firms with market power maximise their profits in the short run by setting the price at whatever level allows them to sell the profit-maximising quantity. As we discuss in class, this is the quantity where marginal revenue (MR) is exactly equal to marginal cost (MC). However, next week in my ECONS101 class we'll be looking in more detail at pricing strategy, and in particular we'll be talking about circumstances where it may be better for firms not to operate at the quantity where MR is equal to MC. Often, firms do this for strategic reasons (for example, as I discussed in this post a few weeks ago, about discounted toilet paper).

One strategy that firms may employ is to sell at a much lower price than the short-run profit-maximising price. So, it was interesting to read this article on View from the Wing recently:

One Mile at a Time noted $16 one way fares on American Airlines between Miami and Los Angeles. These are ‘basic economy’ fares that usually aren’t changeable (although they are right now to encourage bookings) and don’t allow advance seat assignments (but with planes empty you can more or less have any seat you wish).

These aren’t even the lowest cross country flights that are out there. For the next 30 days you can buy Fort Lauderdale – Los Angeles for just $12.89. (After that the lowest fare jumps to almost $27.)

As the article notes, those prices are below marginal cost (which is estimated at $20-$25). Why would the airlines offer airfares at below marginal cost? This is clearly not short-run profit-maximising behaviour (and is clearly not the price where MR=MC, since by definition that price must be equal to, or greater than, MC). Even if you take the view that having some consumers is better than none if the flight is going to fly anyway, selling tickets at below marginal cost would still make the airlines worse off than keeping the seats empty (because the cost of providing that seat, MC, is less than the price).

So, the airlines must be making a strategic play here. The article offers six possibilities, but I find these two the most persuasive:

1. Avoid shutdown. They want to show they still have some passengers, that people still need to get around, so that the federal government doesn’t order total shutdown of airlines. A shutdown is itself costly because it means parking planes and prepping them for storage, and pilots lose their ‘current’ status without enough takeoffs and landings.

2. Persuasive for a bailout. Consumer demand will be part of their application for bailout funding. The legislation has been passed but airlines still have to apply and their applications need to be approved.

If airlines are looking to profit-maximise and taking a long run perspective, then both of these options make sense. After all, for most airlines right now, they are concerned about their very survival. Even though they may be making losses on every passenger in the short run, avoiding being shut down completely and strengthening their case for a government bailout may result in higher profits (or, let's face it, lower losses) overall. At the least, it might help them survive into the future.

Firms' pricing strategy in the real world often isn't as simple as the MR=MC condition makes it seem. A broader perspective is often necessary for us to understand the complexity of pricing strategy, especially when firms like these airlines appear to be deviating significantly from short-run profit-maximising behaviour.

[HT: Marginal Revolution]