Hub-and-Spoke System in Airline Industry: Cost Efficiency and Competitiveness

1. The Hub-and-Spoke Routing for Airlines Costs and Competitiveness

2. Background • Airline industry during regulation • Entry into the airline industry was limited • Between 1950 and 1974 CAB rejected applications from 79 possible new airlines • Airline routes were awarded by Civil Aeronautics Board (CAB) • Airlines cannot create the route network in the most efficient way

3. Airline Deregulation Act of 1978 • 1975 route suspension ended • CAB allows competition in a market where incumbent was satisfactory • Deregulation Act of 1978 • Allowed entry into markets unless incumbents can show not in publics best interest

4. Effect of Deregulation • Creation of the Hub-and-Spoke system by major airlines • Routes quadrupled in 18 months • Lower airfares (yield) • Better service • Many market exits

5. Advantages of Hub-and-spoke • Consolidation of passengers (economies of density) • Decreased number of routes • Increase demand (frequent flights) • Consolidation of activities (personnel, maintenance, etc.) • Decrease costs

6. Implications • Hub-and-spoke should decrease the cost of airlines • The more intense the hub-and-spoke system, the lower the unit cost should be • Historical data (pre and post deregulation) should indicate this trend – Study in 1986

7. A Measure of Hub-and-Spoke • % of departures from hub airports (hub ID by airlines) • % of departures from N airports with largest departures • Top 3% of departures coming from locations • Upper limit = .5

8. Sample and Descriptive Statistics • 1970-1984 • 21 airlines

9. Econometric Model • Airline cost is a function of: • Labor • Fuel • Capital and materials • Average stage length • Average load factor • Number of airports (points) • Outputs • Hubbing intensity

10. Results • Model estimation result – Table 4 • For every 1% increase in hubbing, unit costs fall by .11% • It does not seem like much, but in 1984 the airline industry may have saved 2 billion dollars due to increased hubbing

11. Hub Characteristics • Centralized location which minimizes travel on each spoke • Located in large cities • Upper Midwest examples (Chicago, Minneapolis, Detroit, St. Louis)

12. Implications for Competitiveness • Desirable hub cities do not have the capacity to become hubs for all airlines • Most desirable cities for hubs are already taken • Airlines without hubs at desirable locations may be in disadvantage • Monopolistic behavior?

13. How About Point-to-Point? • Big exception of Southwest (SW) • SW uses P2P – should have higher costs than others • Provides cheap fares (Figure 1) • The only profitable carrier in the US (see Table 1) • Other majors are in and out of financial ruin since deregulation • Similar models emerging in foreign countries

14. Other Way Round? • Hubbed fims begun to offer short-haul P2P to keep SW at bay • E.G. United Airlines, the largest airline in the world at the time, started United Shuttle (which made direct flights) • Used $1 billion to fight against SW • This and similar attacks all failed

15. Other Way Round? (cont.) • Clearly, the benefit of hubbing does not lie in the ability to charge low prices • Increase in non-hub routes by majors – 134 new nonstop routes in the last year only (New York Times) • Why? Is theory not working?

16. Discussion Questions • What are the pros and cons of Hub-and-spoke system? • What is the future of hub-and-spoke system? • Are there any other ways than hub-and-spoke to increase density and lower cost? • From the passenger viewpoint, what are the pros and cons of hub-and-spoke system? • Can hub-and-spoke work as a barrier to entry? Under what circumstance? • What is the solution(s) for capacity problem?