The Southwest Effect May Not Be All It's Cracked Up to Be

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The so-called "Southwest Effect" has been back in the news lately, after Southwest Airlines (NYSE: LUV) announced that it plans to begin flying to Hawaii next year. This phrase was first coined in a DOT report in the early 1990s, and it refers to a pattern of lower fares and higher passenger traffic after Southwest Airlines enters a new market.

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Some pundits have argued that Southwest's entry into the West Coast-Hawaii market will lead to big savings for consumers. Many proponents of this view have cited a recent University of Virginia study that claims the Southwest Effect is alive and well. Other pundits have questioned whether the Southwest Effect is really still intact -- or whether it will apply to Hawaii.

There's definitely room for fares to fall on some routes to Hawaii. But in general, the evidence for the Southwest Effect isn't nearly as clear-cut as the authors of the University of Virginia paper would have you think.

The changing competitive position of Southwest Airlines

The original DOT study of the Southwest Effect found that on several California routes, the arrival of Southwest Airlines in the market caused fares to fall by about 50% and traffic to more than triple. This highlights the massive impact of Southwest's growth on air travel at that time.

Clearly, Southwest doesn't have such a dramatic effect anymore. Legacy carriers like American Airlines (NASDAQ: AAL) and Delta Air Lines (NYSE: DAL) have cut their costs through the bankruptcy process, while Southwest's own costs have risen. In addition, there are far more budget carriers around today, including ultra-low-cost carriers like Spirit Airlines (NASDAQ: SAVE) that have significantly lower costs than Southwest.

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The authors of the University of Virginia study acknowledge these factors. However, they note that Southwest's transition to flying longer routes -- which obviously have higher fares -- means that even a smaller percentage drop in the average fare could lead to big savings for consumers.

The case for the Southwest Effect today

The authors assert that the Southwest Effect has remained significant even in the past five years. Specifically, their study finds that fares fell by an average of 15% and traffic grew by an average of 28% on routes where Southwest has added service since 2012. In addition, they find that fares are $45 lower on routes served nonstop by Southwest, controlling for various other factors.

A case study of Dallas is perhaps the most convincing part of the paper. The authors show that after Southwest Airlines added 34 new routes out of Dallas Love Field in late 2014 and 2015, fares on those routes fell by an average of 25% and origin-and-destination traffic (as opposed to connecting traffic) increased by 37%.

Sifting the evidence

In evaluating the significance of the Southwest Effect, it's important to remember that airfares have fallen throughout the U.S. in the past three years or so. This has occurred even in markets where Southwest isn't growing much.

Consider Seattle. Seattle-Tacoma International Airport has been the fastest growing major airport in the U.S. for the past few years, thanks to a fare war between local heavyweight Alaska Air (NYSE: ALK) and Delta Air Lines.

Delta has more than quadrupled the number of daily flights it operates in Seattle since the beginning of 2013. Alaska Airlines has responded by cutting fares and adding more service. As a result, the average fare in Seattle has fallen from $380 in 2013 to $333 for the past four reported quarters. This is almost exactly equal to the decline in airfares seen in Dallas during that period. Meanwhile, passenger traffic in Seattle surged by 31% between 2013 and 2016.

(In case you were wondering, the average number of daily departures on Southwest Airlines in Seattle ticked up only marginally between 2013 and 2016, from 34 to 37.)

The regression analysis showing that fares are $45 lower in Southwest Airlines markets also seems open to question. The study's authors don't control for market size. However, Southwest only flies to cities large enough to support service on full-size mainline jets. Fares in smaller cities that mainly see the regional jet and turboprop flights tend to be much higher, but that's largely because unit costs are a lot higher for those smaller planes.

Thus, it's possible that fares are lower on routes served by Southwest simply because they are popular routes served by large planes that have low unit costs. The regression may not be measuring the Southwest Effect at all.

Even in Dallas, the Southwest Effect may not have been quite as powerful as it seemed. In 2015, American Airlines -- by far the largest airline in Dallas -- started matching the fares of ultra-low-cost carriers like Spirit Airlines. At the time, Spirit operated on 25 high-traffic routes in Dallas. American's price-matching activity would have led to falling fares and higher traffic in Dallas during 2015 even without Southwest's expansion at Love Field.

Competition is really the key

Southwest Airlines still helps bring down fares and boost traffic on routes where it adds service. It's just the existence of a specific "Southwest Effect" that's doubtful. Seattle has experienced an equally powerful "Delta Effect" over the past few years, even though Delta has a relatively high cost structure and isn't known for low fares.

To be blunt, it all boils down to competition. The more competition there is in a given market, the lower fares are likely to be. Who exactly the competitors tends to be less important (especially if at least one is a low-fare carrier).

Circling back to Hawaii, the biggest West Coast-Hawaii markets already have four or five airlines competing today. As a result, Southwest Airlines isn't likely to bring fares down that much. By contrast, Southwest's entry into the Hawaii market is likely to have the biggest impact on routes where only one or two airlines provide nonstop service today.

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Adam Levine-Weinberg owns shares of Alaska Air Group, Delta Air Lines, and Spirit Airlines. The Motley Fool recommends Spirit Airlines. The Motley Fool has a disclosure policy.