Bureaucrats Assume Supply Is Inelastic
A friend told a story once about flying next to a homeless man on a Spirit flight from Myrtle Beach to New York. He is an excellent storyteller. It was entertaining, but he related the experience to make a broader point: Spirit’s fares were cheap enough for anyone to fly, regardless of economic circumstance.
In Europe, there are myriad budget carriers like Ryanair and EasyJet. This is true in Asia too. They have AirAsia, Cebu Pacific Air, Jetstar, NokAir, IndiGo, SpiceJet, Tigerair, Lion Air Group, and Akasa Air.
You’d think there would be more ultra-low-cost carriers in the US. It’s a big country. But the challenge of keeping the lights on is formidable. You sell tickets weeks or months ahead of the flight, locking in pricing. A high proportion of costs are fixed (aircraft, routes and terminals, wages, technology), but there are variable costs related to things like fuel that can be volatile. The complexity of planning that goes into operating an airline is high, especially in a country like the US. You have to make sure the planes are where they are supposed to be, when they’re supposed to be there. They need to be well maintained. They need to be crewed. All of this is subject to the cut of a thousand budget constraints like work rules, safety requirements, the weather, and a host of other things.
Your ability to change prices to reflect fluctuations in the price of fuel is limited by your pricing power: what kind of ticket price inflation will your customer base tolerate? This is determined by things like the competitive dynamics in your market segment, in this case the low-end. These people fly because they can afford to do so. Raise the cost too much and they won’t travel, at least with you. Empty planes don’t pay for themselves. The marginal cost of flying a passenger is limited to the incremental fuel and food you must onboard. With these kinds of customers, in competitive markets, one temptation would be to price as many customers at marginal cost as possible to gain share. That’s a slippery slope. You aren’t covering the capital charges for your aircraft and other infrastructure. You’re not covering your interest expense on debt incurred to purchase the planes. You’re not covering your other fixed costs, e.g., the compensation for your aircrew.
Pricing for these carriers is sticky. Once you start discounting, it’s hard to resume pricing at higher levels. It’s hard work being a low-cost carrier.
The best ones will sweat the planes more efficiently, with faster turnaround times, so that they can get more passenger miles per day than the traditional carriers. Ryanair wrote the book on this approach. Or you fly out of secondary airports with lower fees a la EasyJet. If you’re lucky, you don’t have unionized labor. You fly a single type of aircraft and you minimize hubs, with simplified route planning, to cut down further on complexity. If you’re lucky, you have a young fleet, staffed by cheap, young, non-unionized people who are paid in large part in glamor. This was JetBlue’s startup playbook. It worked for Virgin when they launched and Southwest, too, back in the day.
You’re still subject to the whims of the things you cannot control, like the weather or the price of jet fuel. You can try to insure against weather blockages, but that’s not easy to obtain at a price that makes sense. As for fuel, there are ways to hedge, but you can still lose. Hedge too soon and you forego any fall in the price of fuel. This is the problem with hedging against revenue as it comes in. You need every dollar of profit, however you get it, especially if you’re being aggressive on price. Failure to hedge the price of fuel leaves you exposed to fluctuations. If it ramps up, you can end up covering at the top. You will be miserable if the price falls after you cover but before you recognize the revenue, seeing that you locked in a loss that you might have avoided. Even if you hedge the price of crude, if refinery conditions tighten, the basis between kerosene and crude can spike against you. You can’t hedge the basis as easily, unless you buy your own refinery.
That’s not to mention fluctuations in interest rates and changing liquidity conditions in credit markets that affect the price you pay for financing, or if you can access it at all.
God forbid credit conditions, wages, and the cost of jet fuel move against you simultaneously, especially if you operate in markets that are irrationally competitive, limiting your ability to share this risk with the customer.
It’s easy to paint yourself into a corner where you have all of the downside and none of the upside.
For an example of how things can go wrong for ultra-low-cost carriers in volatile environments, look no further than Skybus Airlines.
“A statement on its website regarding the shutdown said that ‘Skybus struggled to overcome the combination of rising jet fuel costs and a slowing economic environment. These two issues proved to be insurmountable for a new carrier.’ Skybus was the fourth United States-based airline to shut down or announce future plans to shut down the week of March 31, 2008, following Aloha Airlines' passenger operations, ATA Airlines and charter airline Champion Air.[7] At the time of the shutdown, Skybus employed about 450 people, mostly in the Columbus, Ohio, area. Almost all were immediately laid off. Passengers were also left stranded before they could complete their round trip flights.”
Spirit has stepped on all of these rakes. It is not healthy, by any stretch. Sometimes, a merger is the cure, especially if it can fix competition in markets where irrationality dominates. Here’s the New York Times:
“Before it struck a deal with JetBlue in July 2022, Spirit was struggling. Unlike larger airlines, it never fully recovered from the early days of the pandemic in 2020. The budget airline is losing money, and some analysts say it is hard to see how Spirit can dig itself out of its financial hole without finding another buyer. Some airline experts say the carrier might have to file for bankruptcy protection.”
So, it was surprising to see the Justice Department win in its efforts to block the deal. The Justice Department and the FTC have been criticized by antitrust experts for focusing on cases that are marginal in order to force companies (regardless of industry) to second-guess every potential deal. See for example, this open letter.
“Seventeen former chief economists of the Federal Trade Commission and the Department of Justice Antitrust Division urge current Agency heads to separate the legal and economic analysis in the draft Merger Guidelines to strengthen the role of the latter in merger review.”
Returning to Spirit, the Justice Department won the case. Risk arbitrage players betting that the court would cite precedent in the airline industry for the consolidation of failing players lost their shirts. Here’s the FT.
“On Monday, a US federal judge nixed JetBlue’s all-cash buyout for Spirit Airlines, with an equity value of $3.8bn. The court decided that Spirit’s ultra-discount model was too important in the airfare marketplace to sacrifice in the deal. Instead of getting about $34 per share, Spirit equity holders have a piece of paper trading for $6.”
What was the judge thinking? The New York Times quotes his judgment here.
“Judge Young agreed with the government, ruling on Tuesday that the merger would ‘likely incentivize JetBlue further to abandon its roots as a maverick, low-cost carrier.’ He said Spirit played an important role in the market as a small, low-cost alternative to large airlines.
“’Spirit is a small airline,’ he said in the ruling. ‘“But there are those who love it. To those dedicated customers of Spirit, this one’s for you.’”
The President weighed in, too.
“President Biden hailed the ruling as a win for consumers in a post on the social media site X and said that his administration would aggressively enforce antitrust laws. ‘Capitalism without competition isn’t capitalism — it’s exploitation,’ he said. ‘Today’s ruling is a victory for consumers everywhere who want lower prices and more choices.’
“Spirit’s share price tumbled 47 percent by Tuesday afternoon following the news, while JetBlue’s share price closed up 5 percent.”
You know what else capitalism is known for? It’s renowned for what Joseph Schumpeter called “creative destruction:”
“Basically, the theory of creative destruction assumes that long-standing arrangements and assumptions must be destroyed to free up resources and energy to be deployed for innovation. To Schumpeter, economic development is the natural result of forces internal to the market and is created by the opportunity to seek profit.
“Creative destruction theory treats economics as an organic and dynamic process. This stands in stark contrast with the static mathematical models of traditional Cambridge-tradition economics. Equilibrium is no longer the end goal of market processes. Instead, many fluctuating dynamics are constantly reshaped or replaced by innovation and competition.”
Creative destruction means deploying capital to its most productive use. At some point, investors may decide to put Spirit in the “too hard” pile and it will go the way of Braniff.
Applying this framework to Spirit and seeing the price action in the immediate aftermath of the deal’s rejection, professional investors in the equity (with the ticker “SAVE” for good measure) realized their losses and moved on, having little confidence that the stock could regain its previous levels anytime soon. It was better for the professionals to re-allocate their diminished funds to something else that was more likely to move higher. Doing so makes them responsible agents for the people who give them capital to invest in the first place.
Whatever Spirit’s out-of-the-money real option on survival equity does now is more likely to be determined by day-trading meme monkeys, at least in the near-term.
Implicit in the judge’s “your welcome” message for Spirit shareholders is the assumption that Spirit will survive in its current form. Current Spirit passengers will continue getting that same Spirit service for that same Spirit low-low price. The judge discounts the possibility of Spirit changing its behavior, or even failing.
In the aftermath of the ruling, credit ratings agency Fitch placed Spirit’s standalone B- credit rating under review.
“Spirit faces significant refinancing risk in the next year with its $1.1 billion loyalty program debt coming due in September 2025. Meanwhile, the company faces serious headwinds toward improving its profitability including engine availability issues, overcapacity in certain leisure markets, and intense competition.
“In the near term, we expect Spirit to focus on shoring up liquidity. The company entered into sale-leaseback transactions for 25 aircraft, which netted roughly $419 million in cash. Other sources of liquidity could include potential additional sale-leasebacks, EETC offerings, financing the Dania Pointe headquarters campus, and engine-linked payments from Pratt & Whitney. Overcoming standalone refinancing risk will ultimately be dependent on restoring market confidence in the company’s ability to establish an operational/strategic plan that enhances profitability and generates adequate cash flows.”
Boiling this talk down to cold English, Spirit has a massive amount of debt that’s due in 2025. They’re borrowing against anything they haven’t used as collateral yet, hoping to take those funds to be able to pay the 2025 maturity. But they’re still up a creek without a paddle unless they can stop the bleeding.
Are consumers better off if Spirit ends up liquidating?
Will anti-trust enforcers even allow incumbent carriers to purchase Spirit assets in liquidation? Would they permit Delta to purchase Spirit aircraft, for example? My guess is they would not.
This is a case study in a broader problem. Bureaucrats assume that supply is inelastic to their administrative predations. The bureaucrat has convinced himself that he can tax or regulate this economic actor and nothing will change. Creative destruction puts the lie to this malevolent fallacy, It is poisonous precisely because it enables the bureaucrat to wreak his havoc by taking the cost out of the cost-benefit calculus. For the bureaucrat, there is only the partial equilibrium, not the general one.
Another good example of this is found in the US fisheries industry.
“The plaintiffs in the Loper Bright Enterprises, Inc. v. Raimondo case are a group of herring fishermen from Cape May, N.J., who are challenging a 2020 regulation issued by the National Marine Fisheries Service that requires them to pay around $700 per day for human monitors to be put on their boats when asked to ensure they adhere to fishing regulations.
“The nonprofit organization added that the monitoring costs can take up as much as 20% of a ship’s daily take-home pay and ‘’presents a huge burden that could easily drive these fishermen out of the herring business.’”
The appeal of this case has reached the Supreme Court where its significance outstrips the immediate issue of just the per diem tax imposed on them without statutory direction. The fishermen are also challenging the blind deference to administrative authority in cases in which the relevant legislation is not crystal clear. That case is the subject for another day.
But the key takeaway for the purposes of our immediate argument is that the bureaucrats who thought this was a good idea assumed that the fishermen would suck up the fee and continue operating as before. Maybe they would raise the price of herring. The bureaucrats seemed to think that nothing would change fundamentally.
In the real world, we live in a complex, adaptive system. It is organic, not mechanical. There is no equilibrium, only dynamic flow. It is chaotic. The assumption that we are (and forever will be) in a stable equilibrium is one of the principal weakness of the bureaucratic dogma.