Why Airlines Changed Their Pricing Structure

Not too long ago, airlines tended to price all of their seats in the same range, but that's changing recently.

In this segment from Industry Focus, analyst Sarah Priestley and Motley Fool contributor Adam Levine-Weinberg explain how the airline industry decides what to charge for each seat on a plane, why so many companies are switching to a more a la carte model, and how it's affecting their bottom lines.

A full transcript follows the video.

This video was recorded on Sept. 14, 2017.

Adam Levine-Weinberg: Going off of that, on the revenue side, one of the interesting developments in the past 10 years, and it's continuing to develop even today, is how airlines have gone from being all the same in terms of how they price their product to being quite different. So you see that with, on the one hand, you have Southwest (LUV -0.90%) Airlines, which is the biggest domestic carrier in the U.S. It has about $20 billion in revenue. And while that's about half of what Delta (DAL -1.93%), American (AAL -1.05%), and United (UAL -2.81%) bring in, those three carriers have these massive international networks, as well. Southwest, if you look at them, they don't charge for bags. You can still check two bags for free. Carry-on bags, of course, are free, as well. They don't have any change fees, so if you want to change your itinerary even up to the day that you're traveling, you do have to pay any difference in the fare between what you purchased and the flight you changed to, but you can cancel or change with no penalty. And that's completely different from the other airlines, which typically will have $150-$200 change fees, they'll charge you $25-$35 per bag that you check, and they have a variety of other fees. So Southwest has really stood out by having this bundled product where there's no hidden fees. And they really promote that in their advertising.

Sarah Priestley: And I think they really appeal to the leisure traveler. I think there are two really distinct categories of travelers for airlines. Business travelers tend to be a lot more brand loyal, into the rewards program, they're a more lucrative traveler. And leisure, obviously much more price sensitive, and tend to be price loyal. But as you said, Southwest, without having any of the hidden charges, and also being priced competitively, too, makes an attractive proposition for people.

Levine-Weinberg: Yeah. And at American, Delta, and United, as I've said, they started adding these bag fees and high change fees. But what they also started to do more recently is, they're dropping a lot of their fares in the lowest fare classes. Airlines, as a very quick side note, have a very complicated pricing structure. Revenue management is a science that they really focus on. So they're trying to figure out, how can we squeeze the most money out of each flight that we can? And that's not necessarily by charging high fares across the board. They'll try to figure out basically on a customer-by-customer basis how much that person is willing to pay, and charge that fare. If you book really far in advance, you're probably a leisure traveler. Business travelers don't know their schedule four months ahead of time. So those fares tend to be low. And when you get very close to the date of travel, those fares can go up quite substantially. More recently, you've seen Delta, American, and United introduce these basic economy fares, where they've taken even more perks out of the fare structure. So for American Airlines and United Airlines, that goes as far as, you're not even allowed to bring a carry-on bag at all. And they do that so that people who are needing the carry-on bag, especially if you're a business traveler, you want to get off the plane quickly, you don't want to check your bag, you're going to have to buy the next fare class up. So that's a way of allowing these carriers to match a low-cost carrier's flight. So they can say, "We're offering fares as low as $49 in this flight." So if someone is really price sensitive, they'll snap up that fare. But a lot of people will buy up the higher fare classes, so they'll be able to maximize revenue while still offering low fares to the people who really want that. And most of the airlines seem to think that's necessary. They don't want to give up all that traffic to companies like Spirit Airlines and just only get the people who are willing to pay $150 or $200 one way.