Economists Do It With Models

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I Can Only Hope They Understand Economics, Airlines Edition…

September 18th, 2009 · 9 Comments
Econ 101

Today my best friend is on a plane to Nashville. As such, I woke up to the following tweet:

“Glad I’m trusting my safety to a company that thinks it’s likely the plane will land upside-down… http://twitpic.com/i6c6y

Okay, maybe that was tweeted somewhere around 12:30, so technically I wasn’t still sleeping. (Or at least won’t admit to it.) Regardless…this is the picture that he took:

Well that doesn’t exactly inspire confidence now does it. I feel like the world reads my mind sometimes, since an hour or so later, when I was settling in for my daily dose of The Onion, I came upon the following:

See, it’s funny because it’s true. It’s also funny because it’s more timely than The Onion perhaps realized: The Consumerist has a post today entitled Southwest Airlines Will Save $100,000 By Getting Rid Of Lemons. Ha. This reminds me of the incident back in 1987 where American Airlines famously achieved cost savings by by eliminating olives on salads in in-flight meals. (The estimates of the cost savings range from $40,000 to $70,000.) But is this a good strategy?

The answer is that it depends. Presumably, the airline cares about overall profit and not just revenue or cost independently. The key point is that the airline needs to understand by how much consumers change their valuations of the service being offered. There are a number of ways this could/should go:

Option 1: Maybe airline passengers don’t care about lemons

The important part to remember is that the supply of airplane flights depends on the cost of an airplane flight. Therefore, when Southwest took away the lemons, the supply curve shifted down by the cost of lemons per flight. Alternatively, this cost savings would mean that more flights are supplied at any given price. Nothing happens to the demand for flights, since customers willingness to pay is unaffected. (In other words, they didn’t change how much they value a flight.) Since the equilbrium in the market is where supply and demand intersect, we see that in this case the airline ends up offering more flights at a lower price.

But wait- why doesn’t the airline just keep the price the same and pocket the savings? (In practice, they probably did, whether or not it was the smart thing to do.) The key fact here is that the supply curve represents all of the points that are profit-maximizing for the airline. Therefore, it’s profit-maximing for the airline to now lower its price a little (but not by as much as the cost savings) in order to sell more tickets. The bottom line here is that the firm wins by taking away the lemons in this case.

Option 2: Maybe airline passengers care about lemons, but don’t care as much as the lemons cost the airline

In this scenario, the supply curve moves as before, but now we get a shift in demand as well. Since demand represents consumers’ valuation of an item, the demand curve moves down by the amount that consumers valued the lemon in their Coke or whatever. (Yes, I realize that not all consumers value the lemon the same, but just work with me here, since that point doesn’t affect the overall conclusion.) However, it shifts down by less the the supply curve shifted down, since consumers don’t care as much about the lemon as it costs in this case. The outcome for the airline is similar to that of the first option, but not quite as favorable. The important part is that it is unambigious that the airline ends up doing better by taking away the lemons.

Option 3: Maybe airline passengers care a whole lot about lemons

Now, Houston, we have a problem. If the consumers’ valuation of the lemon is larger than the cost savings that removing the lemon gives, we get a situation that looks like the one above. Now the airline ends up selling fewer flights at a lower price. Hm. That doesn’t sound good. But wait- the airline is now enjoying a cost savings…maybe that makes up for the price and quantity decrease?

Sadly, no. If you look at the points on the old and new supply curves at the original quantity sold, you will notice that both of those prices are higher than the price that persists in the new equilibrium. This, in better English, means that the price drops by more than the cost savings. This, coupled with the decrease in quantity of flights sold, is clearly bad for the airline.

Notice that there is a general principle at work here: it’s profitable to offer an amenity if consumers value it at least as much as it costs to provide. If the consumers don’t value the amenity as much as it costs to provide, it makes sense to take it away. Funny how that works. In fairness, the Consumerist article points out that Southwest knew that people generally preferred limes to lemons anyway, so taking away the lemons shouldn’t be a big deal for passengers. The site also conducted a very scientific survey of its own, with the following result:

In case you’re curious, yes, I do look into my beverage garnish options when choosing an airline. (Ok, maybe not.) And, before you dismiss this example as trivial and/or intellectually cute, consider that the same principles apply to policies such as the amount of carry on luggage, checked baggage allowances, etc., and these things clearly get people’s panties all in a twist, no?

Tags: Econ 101

9 responses so far ↓

  • 1 Anca // Sep 18, 2009 at 8:59 pm

    A few months ago I have read that Ryan Air wants to charge passengers for the use of restroom in the plane. Another way of reducing costs that can have great implications.

  • 2 Mike // Sep 18, 2009 at 9:02 pm

    Eroding away decades worth of product branding… The “big” airlines practically force me to vote my dollar for the train, Jet Blue, or Southwestern. Actually, I bought a VW diesel and make tons of money (all change) per mile commutted. Who’s the man? The guy driving the terrible smelling (but ruthlessly efficient) car, that’s who!

  • 3 econgirl // Sep 18, 2009 at 9:32 pm

    @ Anca: I’m sorry, all I heard was “I want a post on externalities.” 🙂

  • 4 PeterM // Sep 18, 2009 at 9:59 pm

    As I recall form my ancient regulatory history, under CAB regulation, the airlines were constricted on price competition, so they competed on quality, the problem being that many consumers would have preferred price competition.

    Ah, I remember fondly airplane trips to Boston in the late 1960s, to see my girlfriend. The student fare between Beantown and DC was $14.70 one-way on Northeast Airlines. My girlfriend moved to DC and Northeast promptly went belly up (excuse the Tom Swiftie). We gave them lots of business. Excuse my reverie about Boston. It’s a great city in which to be young.

  • 5 senatorjohn // Sep 18, 2009 at 10:11 pm

    i feel baited by this post.

  • 6 Scott // Sep 19, 2009 at 11:18 am

    Love this post! Glad that a friend recently introduced me to this site. The world needs many more imaginative and grounded bloggers like Econgirl.

  • 7 Don Gooding // Sep 19, 2009 at 1:17 pm

    “The important part to remember is that the supply of airplane flights depends on the cost of an airplane flight. ”

    I think this is a good example of the dangers of conflating market-wide general economic analysis with company-specific business decision analysis.

    Adding more airline flights for a particular airline is lumpy due to the capital intensity of production, the expiration of inventory (unused seats are wasted), the hub-spoke integration of flight schedules, and the volatile pricing of the product (e.g., discounts for early reservations), and the related gamesmanship among airlines in both supply and pricing of flights. So a minor decrease in costs could translate into improved profit margin, a bit more discounting on existing flight inventory to improve competitiveness (increasing sales without increasing supply), or an increase in supply. The precise, very rational response is extremely path sensitive – that is, it depends on the business environment facing the particular airline at that moment in time rather than some eternal economic “truths.”

  • 8 senatorjohn // Sep 21, 2009 at 2:31 pm

    don gooding has the basic problem fairly well outlined. airline economics are completely mental, and have very little to do with base principles of econ.

  • 9 econgirl // Sep 21, 2009 at 4:21 pm

    @ senatorjohn: Well, you should know. 🙂 But let me then register officially my lack of shock that the airlines are having a less than successful time with the whole “being a profitable business” thing.

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