We’re seeing airline industry employees negotiating some huge pay increases at the moment. To me this raises an interesting question — who will be paying for this? While the obvious answer is that these costs will be passed on to passengers, I’m not sure it’s that straightforward.Airline labor costs are increasing massivelyThese are fixed costs that won’t go downWho will be paying these higher wages?Bottom lineAirline labor costs are increasing massivelyLet me start by making it clear that I’m not looking to debate the merits of pay raises for airline employees, but rather just want to discuss the economics of it. I keep having pilots comment how they should make more money than surgeons, because they have hundreds of lives in their hands on a daily basis rather than one at a time, so I don’t think it’s a terribly productive discussion.Airline employees had a really tough couple of years at the start of the pandemic, and certainly weren’t in a position to negotiate any new contracts. With travel demand having recovered and airfare being high, many employee work groups are striking while the iron is hot, and are trying to lock in lucrative contracts.Just to give some examples:While pilots will probably be the most costly work group for airlines, it will go beyond that. For example, American’s flight attendants are seeking pay increases of roughly 50% over the coming years, though it’s anyone’s guess how successful they are.I think it’s important to put some of these amounts into context. Up until now, 2016 to 2019 were the four best consecutive years that the airline industry has ever seen. During the best of times, here are the net profits of Delta and American:Delta’s total net profit over those four years was just over $16 billionAmerican’s total net profit over those four years was just under $7 billionSo Delta’s pilot contract alone is worth nearly half of those net profits. We have to assume American’s new contract is worth at least as much as Delta’s, so it would be worth more than all of the company’s profits.Airline pilots are getting huge pay increasesThese are fixed costs that won’t go downAirlines have obviously faced their fair share of challenges over the years, from 9/11, to coronavirus, to recessions, to high fuel prices. They’ve weathered these in a variety of ways, ranging from receiving government support, to bankruptcy, to just taking losses for some period of time with hopes of better days. The airline industry does love to privatize profits and socialize losses.For airlines, the challenge with these wage increases is that these aren’t just a temporary challenge that they have to deal with, but rather this will become the new normal. Short of bankruptcy, I can’t imagine employee work groups will be willing to accept lower wages in the future.Furthermore, the airline industry is low margin during the best of times, and on top of that is highly cyclical. While we love this industry, it’s a terrible industry for investors (well, unless you’re betting on the peaks and valleys).Delta pilots have ratified a very lucrative new contractWho will be paying these higher wages?This brings me to what I think is an interesting question… how exactly will major airlines having several billion dollars in additional (more or less) fixed expenses be paid for?Of course the obvious answer is that passengers will pay for this in the form of higher fares. However, it’s not really that straightforward:Airline pricing has never been based on the cost of providing air transportation, but rather has been based on how much consumers are willing to pay, which is all about supply and demand; because airlines can’t efficiently adjust capacity, any change in demand can greatly impact the pricing power airlines haveThe airlines with significantly higher labor costs will have to compete with airlines that have significantly lower labor costs; this includes many foreign airlines, as well as more airlines that could pop up in the United States, especially as the pilot shortage subsidesAirline executives seem to take the approach that the industry will just keep getting more and more profitable (remember when former American CEO Doug Parker said the airline would never lose money again?), though there’s a limit to thatSo am I the only one who is curious what exactly the plan is here? Is the idea “oh, we’ll just be able to generate a few extra billion dollars per year in revenue forever?” Or will this permanently change the economics of airlines for investors, and lower margins for them?Frankly I’m a bit surprised we haven’t seen more of a drop in the price of many airline stocks as these kinds of contracts have been negotiated, because they materially alter the economics for some airlines. If American ratifies a new pilot contract that’s equivalent to Delta’s (and that seems like a given), how exactly do you sell the idea of “hey, we’re giving our pilots a pay increase greater than our net profit during the best of times, but don’t worry, we’ll just make more money?”Honestly, no shade is meant by this toward any party. I don’t blame airline employees for trying to make as much money as they can. I respect their professionalism, and they’ve had a lot taken away from them over the years. I just wonder if airlines are headed back into financial ruin if there’s a dip in demand, or how exactly this will all play out.Will airlines be able to pass on these higher wages to consumers?Bottom linePilots at US airlines are securing lucrative new contracts. The incremental value of a new contract for American pilots would almost certainly exceed American’s profits during the best of times.I think airlines have come a long way since filing for bankruptcy was a standard way of dealing with the realities of the industry. However, it seems like these new contracts may be the biggest new hurdle to profitability that they face.Pricing in the airline industry has never been based on a concept of charging cost plus some percent as a margin. Airlines get away with charging what they can, and airlines seem to be operating under the assumption that margins will only keep increasing forever.What’s your take on how this plays out? Will these much more lucrative contracts lead to airlines all raising fares in unison, somehow? Will they simply wipe out most profits at airlines? And what happens when demand drops?

Source: onemileatatime.com