Do enhancements to loyalty programs affect demand? The impact of international frequent flyer partnerships on domestic airline demand.

Frequent flyer programs (FFPs) may allow airlines to exercise market power on routes that depart from airports at which they are dominant. Prior research, however, has not disentangled the effects of FFPs from other advantages that dominant airlines may possess. I exploit variation in the extent and scope of U.S. airlines' FFP partnerships with international carriers to evaluate the economic impact of enhancements to FFPs. The results indicate that enhancements to an airline's FFP are associated with increases in its demand on specifically those routes that depart from airports at which it is dominant.

1. Introduction

* Since the deregulation of the airline industry, considerable attention has been focused on the relationship between airport dominance and the competitiveness of routes departing from that airport. Airlines' reorganization of their networks from point-to-point to hub-and-spoke resulted in a significant number of airports being dominated by a single domestic airline. Although there is evidence that hubs allow airlines to achieve lower costs and offer higher frequency, there is also evidence that airlines are able to charge higher fares and capture a larger share of passengers on routes that depart from their hubs. (1) In analyzing this relationship between airport dominance and route-level market power, both academics and policymakers have argued that frequent flyer programs (FFPs) may provide dominant airlines with a competitive advantage. Because the marginal value of FFP points increases with the number of points already accumulated, FFPs give consumers an incentive to concentrate all of their flying with a single carrier. When choosing the airline with which to concentrate their points, consumers will prefer the dominant carrier at an airport because it offers the best opportunities for earning points and redeeming rewards.

The article uses a novel empirical approach to estimate the relationship between FFPs and an airline's demand on routes that depart from airports at which it is dominant. Although existing empirical work has clearly established the existence of a "hub effect," FFPs are likely to be only one of several advantages that dominant airlines possess and therefore only one part of the estimated hub effect. Borenstein (1991) distinguishes between those advantages that result naturally from the carrier's size of operations at an airport (such as the reputation that a dominant carrier acquires) and those that result from institutions created by the carrier (such as FFPs). Although both types may insulate a dominant airline from competition, they may have different welfare implications. The natural advantages may provide some benefits to consumers--for example, through reduced search costs--that may offset the negative effects of the reduced competition that results from having a dominant carrier at the airport. On the other hand, to the extent that FFPs create little social value--and actually distort behavior by exploiting a principal-agent problem--the welfare effects of these programs are more likely to be negative. (2)

Potential policy responses to the observed lack of competition at hubs must weigh the welfare losses that result from reduced competition at hubs against the welfare benefits that result from airlines' use of hub-and-spoke networks. These include cost, frequency, and scheduling benefits, as well as any informational benefits. Selecting the appropriate response requires an understanding of what it is that allows a dominant airline to be insulated from competition. For example, if it is primarily FFPs, then an appropriate response might be a ban on airlines' use of these programs. Doing so might encourage small-scale entry into hub airports while still preserving the many benefits that result from hub-and-spoke networks.

Data limitations have made it difficult to empirically separate the effects of FFPs from the other components of the hub effect. Given this, this article attempts to use a new empirical approach to estimate the relationship between FFPs and demand. Specifically, I estimate the impact of enhancements to an airline's FFP. If FFPs provide dominant airlines with a competitive advantage on routes that depart from their hubs, then enhancements to their FFPs should provide airlines with an even greater advantage on specifically these routes. Intuitively, whereas earlier papers estimate the hub effect, this article estimates the change in the hub effect when airlines enhance their FFPs. Although the estimates cannot reveal what fraction of the hub effect results from FFPs, they can provide evidence on how the relationship between FFPs and demand varies with an airline's dominance at an airport.

The specific type of enhancement that I consider is the formation of FFP partnerships. In the mid to late 1990s, domestic airlines increasingly entered into FFP partnerships with international carriers. These partnerships allowed members of the domestic airline's program to earn and redeem the domestic airline's FFP points on flights operated by partner airlines. Although these partnerships had no direct effect on the quality of airlines' domestic flights, they significantly increased consumers' earning and redemption opportunities in a domestic airline's program. Because of regulatory and financial barriers that limit a domestic airline's ability to serve international markets, FFP partnerships can expand a domestic airline's program to include many international routes that it does not serve on its own.

The ability to earn and redeem on international partners' flights should affect the value to consumers of earning an airline's FFP points on domestic flights through two channels. First, partnerships expand consumers' redemption opportunities in a domestic airline's FFP by increasing the set of available reward flights. Second, partnerships expand the set of flights on which consumers can earn an airline's points. This should increase the value of earning that airline's FFP points on any given domestic flight by increasing the likelihood that consumers will be able to earn enough points for an eventual reward. Because the average international flight is significantly longer than the average domestic flight, international partnerships allow consumers to reach reward thresholds and earn elite status after only a small number of trips.

By expanding earning and redemption opportunities, changes in FFP partnerships generate time-series variation in the value of earning a particular airline's FFP points. I map the changes in partnerships that occur over the sample period into changes in the actual set of flights on which consumers can earn and redeem an airline's FFP points. I then construct variables which summarize earning and redemption opportunities on an airline's FFP partners. These variables are used to identify the effects of enhancements to FFPs on an airline's demand curve on domestic routes. After estimating the effect on demand, I also investigate how enhancements to FFPs impact an airline's number of passengers and fares.

The empirical approach used here can be compared to that used in earlier work on the advantages of airport dominance. (3) Borenstein (1989) analyzes the effects of airport dominance on fares using data from the third quarter of 1987. He finds that, controlling for the overall concentration of a route and for airline and route fixed effects, increases in an airline's share of passengers on a route and at the endpoint airports allow an airline to charge higher prices. Borenstein (1991) estimates the effect of airport dominance on an airline's market share using an empirical approach that controls for airline-city-pair fixed effects. Intuitively, his strategy compares Delta's market share on round-trips between Atlanta and Boston to its market share on round-trips between Boston and Atlanta and relates this to the difference between Delta's dominance at the Atlanta and at the Boston airports. He finds that an airline with a dominant presence at an airport is able to attract a disproportionate share of consumers whose trips originate at that airport and that this effect appears to be smaller on tourist-oriented routes, suggesting that this advantage results from FFPs.

In both of these papers, however, the effects of airport dominance are being identified from differences in airlines' dominance across airports. The estimates on the airport dominance variables capture both the effects of the airline's FFP and any other advantages stemming from the airline's dominance. Because these other advantages also occur only at the dominated airport, they are not being captured even by airline-city-pair fixed effects. As a result, these papers do not allow the effects of FFPs to be isolated.