Case Study 2 — Why Airlines Lose Money Selling $99 Tickets (and Why They Do It Anyway)

Airlines are famous for selling some tickets at prices that seem absurdly low. A $99 coast-to-coast fare on a flight where the total operating cost per seat-mile is much higher than what $99 covers — is this economic insanity?

No. It is marginal cost in action. This case study walks through airline cost structures using the framework from Chapter 17 and shows that the same logic that applies to Riverside Foods applies to airlines — just with different fixed-to-variable cost ratios.

The airline cost structure

Airlines have an extreme version of the fixed-variable cost split.

Fixed costs (for a single flight, once the schedule is set): - Aircraft ownership/lease payment (allocated per flight) - Crew wages (pilots must fly whether the plane is full or empty) - Airport gate fees - Maintenance (scheduled maintenance is fixed per flight) - Insurance - Route overhead (reservations, ticketing, administration)

Estimated fixed cost for a single coast-to-coast domestic flight: roughly $30,000–$50,000, depending on aircraft type and route.

Variable costs (per passenger): - Fuel for the additional weight of one more passenger: about $5–15 - One more meal/snack: about $2–8 - Baggage handling: about $5–10 - Booking and processing: about $3–5 - Airport passenger fees: about $5–15

Estimated variable cost per additional passenger: roughly $20–50.

The key insight: the marginal cost of filling one more seat on an already-scheduled flight is very low — perhaps $20–50. The fixed costs of the flight are already committed. Whether the plane is 70% full or 71% full doesn't change the pilot's salary, the fuel burn (much — fuel is mostly driven by aircraft weight without passengers), the gate fee, or the maintenance schedule.

Why the $99 ticket makes sense

Suppose an airline has a coast-to-coast flight with 200 seats. At current booking rates, 150 seats are sold at an average price of $350 — generating $52,500 in revenue. Fixed costs for the flight are $40,000. Variable costs for 150 passengers: 150 × $35 = $5,250. Total cost: $45,250. Profit: $7,250.

There are 50 empty seats. The marginal cost of filling one more seat is about $35. If the airline can sell those 50 seats at *any price above $35*, each additional sale adds to profit.

At $99 per additional ticket: additional revenue = 50 × $99 = $4,950. Additional variable cost = 50 × $35 = $1,750. Additional contribution to profit = $3,200.

Total profit with the additional 50 seats sold at $99: $7,250 + $3,200 = $10,450.

The airline makes more money selling 50 tickets at $99 than it would leaving those seats empty — even though $99 doesn't cover the average cost per seat.

This is the principle: as long as the price exceeds marginal cost, the sale is profitable for a seat that would otherwise go empty. The fixed costs are sunk. They're paid whether the seat is filled or not. The only relevant comparison is the additional revenue versus the additional cost — which is the marginal calculation from Chapter 17.

Why don't they sell ALL tickets at $99?

If $99 covers marginal cost, why not sell every ticket for $99?

Because the airline also needs to cover its fixed costs. If every ticket on the 200-seat flight sold for $99, total revenue would be $19,800 — far below the $45,250 total cost. The airline would lose $25,450 per flight.

The airline needs most tickets to sell at much higher prices ($200, $350, $500, $800 for business class) to cover the fixed costs. The $99 tickets are only profitable at the margin — filling seats that would otherwise be empty, on a flight where the fixed costs are already covered by higher-paying passengers.

This is why airline pricing is so complicated. The airline is simultaneously: - Selling some seats at high prices to cover fixed costs (full-fare business travelers, people booking late) - Selling some seats at low prices to fill otherwise-empty capacity (vacation travelers booking early, off-peak flights) - Using dynamic pricing algorithms to adjust prices in real time based on demand

The key is that different tickets on the same flight are priced at different levels — and the lowest prices are available only when the airline has excess capacity that would otherwise go unsold. This is price discrimination (Chapter 19 will cover it in depth), and it's driven by the logic of marginal cost.

How this connects to the chapter's framework

Fixed vs. variable costs. Airlines have very high fixed costs relative to variable costs. This means the ATC curve falls steeply as more seats are filled (spreading the large fixed cost over more units) and MC is relatively flat and low. The gap between ATC and MC is large — which is why selling at marginal cost (the $99 ticket) can look wildly unprofitable if you compare it to ATC, but is actually profitable at the margin.

The shutdown rule. Would an airline ever cancel a scheduled flight? Yes — if the expected revenue from the flight is less than the variable cost of operating it. But this is a high bar: the variable cost per flight is relatively low (fuel is the big one, but much of fuel cost is committed once the plane is in the air). Airlines are more likely to cancel flights during severe demand drops (like COVID) when even variable costs aren't covered.

Economies of scale. Airlines benefit from enormous economies of scale — the fixed costs of maintaining a route (aircraft, crew, gates, maintenance) can be spread over many flights and many passengers. This is why the airline industry tends toward consolidation: larger airlines have lower per-passenger costs because they spread fixed costs more widely. (It's also why small airlines frequently go bankrupt — they can't achieve the scale needed to cover their fixed costs.)

Diminishing returns. At very high load factors (95%+ of seats filled), marginal costs start to rise because of operational complications (overbooking, rebooking costs, passenger dissatisfaction, crew overtime). Most airlines target an optimal load factor of about 80–85%, where marginal cost is low and operational efficiency is high.

The COVID lesson

The COVID pandemic was a natural experiment in airline cost structures. When demand collapsed in March 2020, airlines found themselves with enormous fixed costs (aircraft leases, crew contracts, gate agreements) and almost zero revenue. Variable costs could be reduced (fly fewer flights, use less fuel) but fixed costs were largely immovable in the short run.

U.S. airlines received about $54 billion in federal aid through the CARES Act's Payroll Support Program — specifically to cover the fixed labor costs that the airlines couldn't reduce. Without the aid, most major airlines would have entered bankruptcy. The aid was, in economic terms, a recognition that airline fixed costs are so large that the industry cannot survive a demand collapse without external support.

The recovery was also instructive. As demand returned in 2021–2022, airlines that had maintained their fixed-cost infrastructure (kept their aircraft, retained their crews, held their gates) were able to ramp back up quickly. Airlines that had shed fixed costs (parked aircraft, let experienced crew go, gave up gates) recovered more slowly. The fixed costs that were a burden during the collapse became an advantage during the recovery — they represented capacity that could be activated quickly.

What this case study illustrates

Lesson 1 — Marginal cost, not average cost, drives pricing decisions. The $99 ticket is profitable because it exceeds marginal cost — even though it doesn't cover average cost.

Lesson 2 — High fixed costs create the incentive for aggressive marginal pricing. The bigger the gap between ATC and MC, the more room the firm has to sell at low prices on the margin while still covering fixed costs on the base.

**Lesson 3 — Airlines are not "losing money" on $99 tickets.** They are *making money* on those tickets — $99 minus $35 marginal cost = $64 contribution to fixed costs per seat. The alternative (empty seat) contributes $0.

Lesson 4 — Cost structures determine competitive dynamics. Industries with high fixed costs and low variable costs (airlines, software, streaming, telecoms) tend toward price discrimination, economies of scale, and consolidation. Industries with low fixed costs and high variable costs (restaurants, personal services, agriculture) tend toward competitive pricing and many small firms.

Lesson 5 — COVID exposed the fragility of high-fixed-cost businesses. When demand disappears, firms with high fixed costs are the most vulnerable — they can't reduce costs quickly enough to survive a demand collapse without external support.

Discussion questions

1. A friend says: "Airlines are ripping us off — the same seat on the same flight costs $99 for one person and $600 for another." Use the cost framework to explain why the airline charges different prices.

2. If the marginal cost of an additional passenger is only $35, why can't you always fly for $35? What determines the minimum fare in practice?

3. Apply the same logic to movie theaters. The marginal cost of one more viewer (once the film is showing) is essentially zero. Why do theaters charge $12 per ticket? Why do they offer $5 matinee prices?

4. Streaming services (Netflix, Spotify) have extreme fixed-cost structures (content acquisition, platform development) and near-zero marginal cost per additional subscriber. How does this cost structure shape their pricing?

5. During COVID, airlines received $54 billion in federal aid to cover fixed costs. Was this a good use of public money? Apply the cost framework and the shutdown/exit rules.