Orbitz: Good For Airlines, Good For Travelers

Orbitz started selling airline tickets over the Internet on June 1, 2001. It is owned by five major carriers and supported to a lesser degree by 37 more “charter associates.” The five owners have almost 80% of the domestic airline travel market, and the associates account for most of the rest – so Orbitz represents a comprehensive, industry-wide initiative.<?xml:namespace prefix = o ns = “urn:schemas-microsoft-com:office:office” />


Orbitz’s charter requires it to display information in an unbiased manner, sorted only by price, number of stops, length of trip or other basic criteria. It is contractually bound to avoid favoritism based on carrier identity, advertising on Orbitz, sponsorship, or any other factor not related to price or quality of service.


In other words, Orbitz is a comprehensive source of information that allows travelers to find easily the best prices for the flights they want. But more than that: Orbitz represents an opportunity for the airlines to reduce the costs of marketing and selling tickets, allowing them to pass on savings to the consumer. Unfortunately for the consumer, Orbitz competitors in ticket selling are trying to use antitrust laws to maintain their position in the market. They claim that Orbitz will have excessive power over ticket selling and will allow the airlines to coordinate their fares to the detriment of consumers.


The reason, however, that Orbitz is beneficial to consumers is the same reason that Orbitz is harmful to its competitors: Orbitz allows the airlines to bypass other players in the ticket selling business who have been exercising their own market power. In order to explain why this is so, it is necessary to discuss in some detail the workings of an extraordinarily complex industry – in particular the role of travel agents and the computer reservation systems.


Travel Agents: The combination of deregulation and the initial stages of the computer revolution produced a complex and shifting fare structure, which gave travel agents a vital role in collecting information for consumers about fares and routes. Now that this function can be performed more effectively and efficiently by computers, travel agents find it increasingly difficult to convince airlines to pay for their services. Before the airlines eliminated them in March 2002, base commissions had fallen steadily since 1995, to about 5%. They were also capped in dollar terms.


Not surprisingly, travel agents would like to maintain high commission levels, because they could use computers to search cheaply and then pocket the money. But high commissions no longer reflect the economic value of the function.


Another problem for the airlines was that travel agents steered customers to whichever airline bid the most, often unbeknownst to the passengers. The airlines could not afford to alienate agents, and so they acquiesced to this practice. Today, the airlines need not play this game: If unbiased information is available, passengers will catch on quickly, and the power of the agents to steer passengers will decline precipitously. If agents can no longer deliver passengers, and airlines no longer must pay them for steering, the airlines can put the savings back into reductions in price and improvements in service, to the benefit of travelers and the airlines themselves. Airlines want to hasten this restructuring. Hence, they support a service that provides the broad and unbiased information necessary to let the market work.


Airlines do want to retain their ability to reward travel agents who perform important economic functions, primarily putting together travel packages and marketing them to customers who might not otherwise travel, or who might otherwise travel on some other airline. The Orbitz charter specifically reserves to the airlines the right to make special-fare deals as long as they are not offered publicly. Packages and bulk sales are allowed.


In the long term, the best solution for consumers would be for airlines to pay no commissions, and for travel agents to be paid by the travelers. If consumers paid directly for services received, the market for information, reservations, packages, and other aspects of travel would work smoothly. A lack of commissions would also indicate that information had improved and that middlemen no longer had the capacity to steer business in return for rebates.


Computer Reservation Systems: Computer reservation systems (CRS), which are not well known to the public, are operated by independent companies that provide travel agents with information about flights and seat availability and book reservations. These companies were started by airlines during the 1970s and soon fell under Department of Transportation regulations designed to prevent any airline from using a captive CRS to obtain a competitive advantage. (To a large extent, the airlines have divested their ownership; remaining airline stakes are in the 10% to 15% range.) Any reservation not made by an airline itself goes through a CRS.


CRSs charge the airlines, not the agents, a booking fee of around $4.36 per flight segment. This cost is not trivial, because ticket bookings average 2.9 segments each, and the total runs to about $12.64 per trip, which is 3.7% of the average fare of $374. CRSs have steadily raised their prices in real terms even as the cost of computing in general has fallen drastically. The fee per segment was $1.00 in 1984. If segment fees had only kept pace with inflation, then they would be about $1.70 – less than half the current fee. If the price had dropped comparably to other computer costs, it would be in the pennies.


DOT rules are to blame for this situation. In the 1970s and thereafter, as some individual airlines invested in CRS systems, other airlines complained that an airline-owned CRS would slant the display of possible flights to favor those of its owner, to the disadvantage of other airlines. Travel agents also complained that they would be affected negatively by airline-owned CRSs. The DOT, acting at the behest of industry incumbents, issued rules in 1984 and 1992 designed to protect against bias in the display of information by the CRSs, and to protect travel agents.


Achieving these purposes had ancillary effects, however. The airlines were prevented from using investment in computer systems as a tool to change the structure of the ticket-selling industry. Continuing investment in CRSs was also discouraged because the rules ensured that carriers that chose not to invest would not be disadvantaged. The effect of the rules is to protect market incumbents and ensure that CRSs maintain substantial market power over the airlines. The system provides, says William Hannigan, president of Sabre, a “legal ability to print money.”*


As long as airlines compete on fares, which – as any browser of the Web can attest – they do, Orbitz will be good for consumers. The savings from increased efficiency will be reflected in lower fares.


Orbitz is also developing a system called Direct Connect that will book seats directly, bypassing the four major CRSs. This will put competitive pressures on the existing CRSs to lower their fees. This alone is worth the cost to the airlines of setting up Orbitz, which was around $150 million. Booking fees are 2.7% of the cost of the average ticket, a total of $2 billion per year. The arithmetic shows that a reduction in booking fees of only 4% would repay the airlines’ costs for Orbitz in a year.


In reality, the reductions will be much more than that. When Direct Connect comes online, its price for a booking will be $4 per ticket, versus the current CRS price of about $13 for a four-segment round trip ticket.


The clear result of these initiatives will be to create good information, which will reduce consumers’ search costs; to put downward pressure on airline agent commissions, which will lower overall distribution costs; and to introduce price competition into the CRS booking function, which will also lower distribution costs.


First, however, Orbitz needs to clear the political hurdles its competitors are putting up: A subcommittee of the House Energy and Commerce Committee recently held a hearing on “Are All Online Travel Sites Good for the Consumer: An Examination of Supplier-Owned Online Travel Sites.” While Congress ruminated, the Department of Justice continued its 2-year-old antitrust investigation of Orbitz, declining to act against it, but refusing to give it an OK either. The DOT Inspector General gave Orbitz a “clean bill” in 2001, but Congress, acting at the behest of the company’s rivals, instructed the DOT to go back and look again. In late June, the DOT reiterated its view that Orbitz is a good thing, though it refused to make that judgment final until the Justice Department makes up its mind.


Hopefully, the government will turn back the challenges to Orbitz and let the Internet and the free market continue to wring transaction costs out of the system, to the ultimate benefit of the traveling public.

* There is considerable irony in the current attacks charging that Orbitz must be anti-competitive because it is the product of joint action by the airlines. Thirty years ago, when individual airlines attempted to obtain competitive advantage by creating the CRSs, the government imposed rules to forestall them, arguing that any unilateral advantage would be anti-competitive. The current rules have been extended annually since 1997 while the DOT reviews them to decide if substantive changes are needed. The rules will expire again on March 31, 2003.