US Airline Woes

More travelers are flying than ever before and yet airlines have a difficult time making money. The airline industry is a tough business to be in. Airplanes, fuel and people are the three biggest costs to airlines. New airplanes cost money and borrowed money is vulnerable to interest rate fluctuations. The price of jet fuel fluctuates with movements in the petroleum markets. Airlines require lots of people to make your flight as smooth as possible. The difficulties of running a profitable airline have pushed some US  carriers into bankruptcy and created incentives to merge. US Airways has been through Chapter 11 bankruptcy proceedings twice and United and Delta each once. American recently filed for Chapter 11 and now it looks like a merger with US Airways is in the works. Mergers, however, often do not work out as planned with the anticipated  managerial efficiencies and scale effects failing to materialize.

How efficient are US airlines? Using data published in a recent Economist article, I investigate the efficiency of US airlines.

To calculate technical efficiency I use data envelope analysis (DEA).  DEA is a non-parametric approach to the estimation of production functions. I use four inputs (global capacity, domestic market share, employees, delayed/cancelled flights)  and two outputs (market capitalization, operating profits).  For those interested in the technical details, I use the 2 stage input approach with variable returns to scale (VRS).

The DEA results are presented in the above table. Total technical efficiency (CRS_TE) can be broken down into pure technical efficiency (VRS_TE) and a scale effect. The total technical efficiency measures indicate that US Airways, Delta, Southwest, and Alaska are efficient since their CRS_TE measures are equal to one. These companies are operating on the boundary of the production possibility frontier. The other companies are inefficient with American being the least efficient. American for example, can reduce its inputs by 99% and still produce the same output (measured by market capitalization and operating profits). This really shows the extent of American's problems. Pure technical efficiency (VRS_TE) is a measure of manager effectiveness. American's inefficiency is coming from a combination of managerial inefficiency (VRS_TE) and a scale effect inefficiency. American has the least effective management and the largest scale inefficiency. The unity value in the RTS column indicates that American is operating with increasing returns to scale. American needs to get bigger and become more efficient. I wonder if US Airways knows the extent of these inefficiencies and how difficult it is going to be to get the merger to work.