Economists Do It With Models

Warning: “graphic” content…

Bookmark and Share
Reader Question: So Should I Just FedEx My Luggage Now?

May 19th, 2010 · 10 Comments
Behavioral Econ · Buyer Beware · Decision Making · Policy · Reader Questions

I’ve gotten a few requests for comment on the whole “airlines now charging customers to breathe on their airplanes” issue, so I will give a bit of an economist’s take on the matter here.

First, a recap for those of you who, unlike me, haven’t been watching the airline industry with baited breath to see what wacky plans for profitability airlines are going to roll out next:

  • Back in 1987 (yep, I’m going back that far), American Airlines became a pioneer in the “becoming a crappy airline” trend by eliminating olives on salads in order to slash costs by a whopping $40,000 per year. Now, $40,000 on its own doesn’t exactly sound like pocket change, but when you compare it to the fact that the old-school airlines have lost some $30 billion since 2000 it doesn’t look so impressive. Put that way, the $40,000 olives are barely a drop in the bucket. On the up side, the airlines would only have to come up with 749,999 other olive plans in order to recover their losses.
  • The olive trend really started to snowball around 2005, when traditional airlines started taking away free pillows, magazines and even pretzels for coach passengers while competing heavily on service for business and first-class passengers.
  • In June 2008, American and United Airlines announced that they were going to introduce fees for all checked baggage. (Fees for multiple bags had existed before that point, but these were the first major carriers to start charging for a first bag.) I wrote at the time about how airlines were basically giving their customers an incentive to be really annoying to their fellow travelers and stuff as much stuff into the biggest carry-on bags as humanly possible. I’m guessing this did not add to the efficiency at the security checkpoints.
  • In September 2009, Southwest Airlines committed the ultimate customer service sin by taking away lemons as a beverage garnish. (Actually, this wasn’t necessarily a terrible idea, since the very scientific polls conducted seemed to indicate that people don’t really like lemons anyway.)
  • In April of this year, Spirit Air started charging from $20-$45 for carry-on bags. This is in addition to whatever existing fees it had for checked baggage, so the only way to avoid a fee with Spirit is to either travel reeaaaaallly light or FedEx your luggage. Or maybe do this:

  • Spirit Air’s policy drew the ire of Transportation Secretary Ray LaHood and Senator Chuck Schumer, who argue that the airline is being misleading in not adequately disclosing the fees before customers purchase their tickets. The CEO of Spirit Airlines countered this accusation pretty unconvincingly:

    Baldanza told Elliott, “Last fall, we identified excessive carry-on baggage as the number-one controllable reason that our planes were being delayed at the gate.” Spirit’s solution is to change the pricing structure so that nobody can avoid a checked baggage fee, thereby reducing the incentive to bring your bag onto the plane yourself.

    Dear Mr. Baldanza: Captain Obvious over here would like to point out that you likely wouldn’t have had the excessive carry-on baggage problem if you hadn’t started charging for checked luggage. (Economic Principle #4: People respond to incentives.) Five other airlines saw a PR opportunity in all of this and publicly committed to not charging for carry-on luggage.

  • In a fun twist, Ryanair actually made those “what next- are they going to charge us for use of the restroom?” jokes a reality when it, well, announced that it was going to reduce the number of lavatories and install coin-operated locks on the doors.
  • Apparently that fun Icelandic volcano cost airlines $1.7 billion. Economically speaking, this *shouldn’t* affect the supply or price of flights since it’s a one-off sunk cost and not an ongoing variable cost (read, it wouldn’t actually be profitable for airlines to raise prices because of this), but, given their behavior up to this point, you never know.

To summarize, as noted in one of the earlier posts:

Hopefully we’re all caught up now. Now, y’all haven’t been very specific with your questions, but I assume that you are inquiring to some degree whether these events are economically reasonable. So let’s discuss…

What you are seeing here is a version of piecemeal versus all-inclusive pricing. Both of these types of pricing arise in various scenarios- all-you-can eat buffets versus a la carte menus, all-inclusive resorts versus hotels where guests pay for the specific services that they use, etc. In the all-inclusive scenarios, the customers who use fewer of the services end up subsidizing the heavier users, since everyone is charged the same price and the company has to make a profit. (This is why I really don’t like going to all-you-can-eat buffets.) In addition, there is a moral hazard issue with all-inclusive pricing, since people consume more services when they are free (on the margin) than they would if they had to pay for them individually, but these services usually aren’t free for the company to provide. The company, therefore, must also take moral hazard into account with an all-inclusive pricing scheme, which makes customer expenditure higher overall than it would be with piecemeal pricing.

When a company charges individually for specific services, there is no risk of people consuming things that they don’t value as much as they cost to produce. (Even if the customer decides that he made a mistake in choosing to consume the service, he still paid an amount higher than the cost of production.) Therefore, in a pure economic sense, piecemeal pricing is generally more efficient, since everyone is paying an amount in line with the cost that they are imparting on the system.

The downside of piecemeal pricing is that it can get quite complex and cumbersome- when you go to a hotel, for example, is it efficient for the hotel to meter your use of the electricity, water, towels, etc. in the room and bill you accordingly? In theory, probably, given the above discussion. From a practical standpoint, however, the variation in usage across customers and the amount of moral hazard probably isn’t enough to justify the effort. I mean, how much excessive electricity can one really consume just because it’s free? On the other hand, a lot of hotels do charge a la carte for Internet access, since it’s a discrete item that some customers really want and others don’t. (Note that the piecemeal pricing still makes sense in this case even though the Internet access is essentially free on the margin for the hotel to provide.)

Now let’s come back to the airline scenario. What the airlines seem to be saying is that it is worth it for them to implement piecemeal as opposed to all-inclusive pricing for their flights and related services. As noted above, this is reasonable when there is substantial variation in the utilization of the services and/or significant potential for moral hazard. In my experience, I’ve often taken the free beverages on a flight even though I didn’t really want them, mostly because they were there and it didn’t cost me anything to take one. I’m guessing that I’m not the only one to do this, so maybe there’s something to be said for the a la carte pricing in this case. The situation with the baggage is somewhat different, however- the vast majority of people take luggage on airplanes, and I doubt that people vastly overpack when they don’t have to pay extra to take a bag with them. These characteristics would imply that the a la carte baggage fees would be more trouble than they are worth. So what gives?

It’s probably not shocking to you that economic robots are much better than actual humans at making consumption decisions with a la carte pricing. The economic robots, for example, would analyze how many bags they would be taking with them, whether they thought they would want a beverage and/or pretzels on board, and how important an airline pillow was to them, and they would make their choice regarding which flight is the best deal accordingly. Humans, on the other hand, would likely realize that it was kind of a pain in the ass to find and compare all of the different costs when choosing a flight and just go with the one that Orbitz says is the cheapest. (I’m a fairly vigilant price shopper, and even I find it annoying when I have to look up the cost of taking my dog on the plane and add that in to the flight cost in order to make an informed decision.) If this is how customers are choosing their flights, then companies like Spirit Airlines have an incentive to structure their pricing with a lower dollar number on the flight itself and a higher dollar number on the shrouded attributes, since customers won’t fully internalize the a la carte prices until after they’ve already purchased their tickets.

This last point seems to be what Secretary LaHood and Senator Schumer are all in a tizzy about, and not without reason. Economists realize that the cost of something is what one has to give up in order to get it, and, by structuring the pricing in an unnecessarily complicated way (unnecessary because most people bring luggage on airplanes, so it’s hard to argue that it’s more efficient to charge separately for this feature), the airlines are effectively adding to the cost of the flights above and beyond the dollar amount on the ticket. They are also potentially causing people who aren’t paying enough attention to the fine print to make unwise economic decisions. (It’s way too easy to say “tough cookies” on this last point when the reality of the matter is that people are human and information is not costless to obtain.)

Restricting the a la carte pricing probably isn’t the way to go, since there are items that make sense to be purchased in this way, and it’s probably more trouble than it’s worth to figure out which items fall in this category and which don’t. (I get a little annoyed when I turn away the in-flight meal that I paid for, but I’m guessing I’m not in the majority, for example.) It could, however, make sense for airlines to have to disclose the piecemeal fees to the consumer up front, and it would even be nice to have some sort of central comparison chart on fees in order to facilitate consumer decision-making. (The latter item is already out there without the government having to mandate it, in fact. Score one for capitalism.)

The reality of the matter is that transporting one’s self on a flying vehicle isn’t cheap, and airlines need to cover their costs in order to stay in business. I think that consumers need to appreciate this a tad more than they already do and not blame the airlines for having to raise prices and cut flights in response to increases in fuel costs and such. The flip side of that argument is that if airlines want people to trust them to simply react to market forces and not be explicitly ripping them off, they might want to stop with the artificial hiding of costs, since that just reeks of sketchiness.

And yes, it might actually be reasonable to FedEx your luggage.

Tags: Behavioral Econ · Buyer Beware · Decision Making · Policy · Reader Questions

10 responses so far ↓

  • 1 walt526 // May 20, 2010 at 2:08 pm

    It seems to me that the easiest solution would be for sites like Orbitz and Expedia to ask you how many bags you are planning to check (or carry-on, if carry-on fees become widespread) and then add those charges for those into the price. For example, on various shopping comparison sites, they show the expected cost of shipping (because some places were selling the item below cost and then charging an unreasonably high S&H).

    If consumers are able to access more information about the pricing structure cheaply, then they will make more informed decisions.

    Also, travel sites like Orbitz, Expedia, etc. don’t have nearly the same ability to hire lobbyists as the airline industry, so passing laws on how they operate would seem to be far less costly than imposing new regulations directly on the airlines. Furthermore, the existing statutes regulating how pricing information is shared on the internet are sufficiently vague that it may be possible for the FTC to impose new regulations on sites that aggregate travel pricing simply by a reinterpretation of existing law. To the extent that airlines might rally their lobbyists to “protect” Orbitz, et al from intrusive government overregulation or whatever, they’ll be facing an uphill battle if they have to lobby to amend existing statutes as opposed to the far easier task of killing new legislation in its infancy (i.e., committee).

    Now of course the various airlines might respond by no longer providing real time pricing information to Orbitz, etc. (as some, like Southwest, already do). In which case consumers will be worse off than they were before because the information asymmetries will be even worse. But my guess is that at least one major airline will realize that there is a competitive advantage to remaining on Orbitz, etc. if its other major competitors withdraw, in which case most will choose to stay (so as to not give up such an advantage). I’m not really an IO guy, so I’m sure that there’s a more precise way or technical term for what I’m describing, but I envision essentially a stalemate in which the status quo with respect to airline participation on Orbitz, etc. will emerge.

    And in fact if prices do reflect common additional charges like baggage fees, then it’s possible that Southwest (which, as you noted, proudly advertises that “bags fly free”) will (re?)join Orbitz, etc. because they’ll feel that the playing field is more level.

  • 2 Michael Tuchman // May 20, 2010 at 2:25 pm

    I think airlines should go the other way – take all inclusive pricing then offer you a nominal discount if you bring on no carry-on bags.

    Ryanair wasn’t too far off the mark. While everyone brings baggage (or is that luggage – which is correct?) people have different utility for carry-on vs. checked baggage.

    I might also point out that checking bagging is somewhat insensitive to incentives because the cost is not monetary but rather the waiting time to claim it and the risk of theft or damage.

    To my knowledge, no airline has ever tried to differentiate itself on how well they take care of your bags.

  • 3 dWj // May 20, 2010 at 3:15 pm

    If airlines have generally been operating with revenues below variable costs, then one or two marginal airlines knocked into bankruptcy by the volcano could reduce competition. Would that raise prices?

    I seem to have seen differing assertions as to whether Spirit’s fee applies to items that fit under the seat in front of you. I’d be willing to pay $10 to make people who bring big suitcases to stuff in overhead bins pay $20, just because I’m spiteful.

    Most Christmases, by the way, I am making ship-versus-check tradeoffs. I don’t buy the suggestion that luggage-service consumption is extraordinarily price-inelastic.

    I do wish disclosure were better, and like walt526′s suggestion to orbitz. I also think Michael Tuchman’s idea of reframing it is probably a good one.

  • 4 Joshua // May 20, 2010 at 4:44 pm

    Good post! I’ll add that there is some behavior here being pushed by the oligopoly-nature of the flight market. Because there are relatively few major airlines, it is easier for companies to add piecemeal pricing to things like checked baggage.

    As for the Southwest lemons, I got a lemon in my ginger ale on my flight just last month, and now I wonder how old it was…
    : )

  • 5 Håkan Arnoldson // May 22, 2010 at 6:43 am

    This phenomenon has been around longer in some places.

    Already in 2004 I had to bribe the woman in the check-in disk for Aeroflot to get my luggage home from Moscow to Sweden.

  • 6 Tom Stevens // May 23, 2010 at 11:32 am

    Regarding ala carte pricing, frequent fliers pay the same price for their ticket, but get a whole bunch more in services, ie. free checked luggage. However, once you lose your status, airlines are serious dicks to their once favored customers. I was Plantinum until February, but now I now get to board last so I have to gate check my bag on full flights. Unfortunately, Delta still managed to lose my luggage. How this is possible, I haven’t a clue.

  • 7 Håkan Arnoldson // May 23, 2010 at 2:49 pm

    I think we can blame security regulations for eliminating competition in terms of comfort and service on airlines. The mandatory inconvenience imposed on all airlines service is so great no one can tell the difference between what is the fault of the airline and not anyhow…

  • 8 J S // May 31, 2010 at 8:10 am

    Cost in time for checked luggage is a significant problem. If you’ve lived like the characters in ‘up in the air’ – long lines to check and long lines and delay to pick up. Pack light and carry it yourself.

    An airline that didn’t charge for luggage and actually got the luggage arranged for pickup as you get off the plane (instead of centralized six miles walking away) would quickly get a marketing advantage. “we get you there fast, and get you in and out even faster” than the competition would be an unbeatable combination.

    Show the value and get pricing (profit) advantage.

  • 9 Why Airlines Should Start Charging For Carry-On Bags | Airport Lobby // Oct 12, 2010 at 9:34 pm

    [...] Behavioral economist Jodi Beggs thinks this principle doesn’t apply to overhead bin space. “[T]he vast majority of people take luggage on airplanes, and I doubt that people vastly overpack when they don’t have to pay extra to take a bag with them,” she wrote on her blog, Economists Do It With Models. [...]

  • 10 Robert // Oct 13, 2010 at 1:26 pm

    I like Michael Tuchman’s idea. Having discounts for not bringing carry on or checked bags is a great idea, although not as much incentive for the airlines. With charging for carry on the airlines makes money on those who buy the ticket before realizing there is extra cost, and on planes loading and unloading faster due to less bags. But with offering a discount carriers only make money on the faster load/unload.

    I’m really curious when Orbitz/Kayak will start to include all the hidden fees in their searches, it’d be a great way for them to show a difference over competition.

Leave a Comment