What Do Airlines Do?

Inside the inner workings of a modern airline

The optimal planning of airlines is one of the hardest problems which businesses undertake today. Airlines must find the optimal network of routes between dozens of airports, choose the right number of flights to run subject to constraints on getting crew home, maintaining the planes, and having flexibility in the event of mechanical troubles, figure out the optimal menu of ticket prices and the correct rules for adjusting the price over time, and allocate the right number of tickets to each class in the menu. It is difficult to believe that they find the right answer, and indeed, they do not. Airlines divide up the planning problem into many units, and optimize each separately. This leads to them demonstrably sub-optimal outcomes, and better organizational structure in the internal bureaucracy of airlines would make them more profitable.

What this calls into question is the assumption that firms and consumers are rational, profit-maximizing agents. Standard practice across a range of models is to assume that firms are making the optimal decisions given information and costs which we cannot observe, and then to infer what those costs must be in order to rationalize the observed behavior. This is believable when optimal behavior is easy to solve for when costs/benefits are known, even if inference is difficult, but difficult to believe when the problem which must be solved by both firm and econometrician is difficult. Airlines are a demonstrable break of this assumption – as I will show, it implicates a large class of problems.

In particular, antitrust authorities will naturally be interested in regulating the airline industry, and preventing the abuse of market power. But what market power? What do we actually know about the conduct of airlines? How can we regulate an industry when not even the participants know entirely what they are doing? And in regulating an industry to minimize distortions in a static model, do we raise the possibility that we might make the existence of airlines unsustainable?