Airline Pricing and Baggage Fees

With the news that American Airlines will increase its baggage fees starting August 14, 2009, I thought it might be nice to have a little note on airline pricing. It is well known that passengers on the same flight will often pay wildly different prices for the same trip. These prices differ by when you purchased, where you purchase, when the return flight is, how you paid, and many other dimensions. Airlines do this because they engage in a pricing practice called price discrimination.

Price discrimination stems from the fact that airlines are not perfectly competitive. Instead, unlike the market for cereal, there are only a few carriers — even fewer at any given airport — and they only go at certain times of the day to certain destinations. Couple that with the fact there are severe financial and regulatory barriers to entry for potential competition, and the result is that airlines have a decided advantage when it comes to choosing what price you get to pay for the privilege of flying with them.

Because airlines are “price makers,” they are going to charge as high a price as possible. Unfortunately for them, they run into two problems: 1) you have no incentive to reveal what your maximum price is, and 2) each person’s maximum price is different due to different personal finances and values. Because of this, airlines (and car manufacturers, movie theaters, and many others) use a pricing scheme called price discrimination to guess whether you are willing to pay a lot or pay a little.

Let’s take the classic example of requiring a Saturday night stay. Airlines know that business travelers are likely willing to pay more than leisure travelers, because the business traveler has to go at a certain time to a specific place, while leisure travelers can be choosy. To force you to reveal which one you are, airlines charge more to a traveler who does not stay over the weekend (business traveler) than one who is willing to stay the weekend (leisure traveler). Note that each passenger gets onto the same flight and costs exactly the same amount to transport, yet one is willing to — and does — pay up to 10 times more for the same trip.

This brings us to the baggage fees. Many people see these fees as add-ons to bring in more revenue to airlines, but that is only part of the story. What these fees really are, are a way to capture revenue without missing out on passengers who are willing to pay slightly less. Think of it this way, before the fees, airlines where still charging you to check a bag, you just did not have to option of not paying for the service if you did not want it. A numerical example might be that before a ticket from Chicago to San Francisco cost $320 whether you checked bags or not. Now, that ticket might be $300 with no bags and $350 if you check bags. What the airline has done by making the fee explicit is capture those original flyers willing (willing to spend at least $350) without missing out on those passengers they missed before — the ones only willing to spend $300! In fact, the best way to think of the baggage fees is not a fee for checking bags, but rather, a discount for not checking bags.

There are other instances of these fees that we have come to accept without thinking of them. One more drastic example is that some passengers might be willing to spend up to $5,000 to fly from New York to L. A., while others may only be willing to spend $500. What should an airline do? They should install a first-class cabin, of course. A first-class passenger only costs marginally more to transport than a coach passenger, but many (often business) travelers are willing to spend a lot more. This is why the typical business airlines have premium cabins while the non-business Southwests, Midwests, and other low-cost carriers do not.

The bottom like when purchasing airfare is that you are not purchasing a flight. Instead, you are purchasing a menu of items including the flight, check-in, meals, drinks, lounges, and everything the airline provides from point A to point B. The airline offers all these different services and add-ons because they know each of you is different, and in order to capture as many rents as possible from each one of you, they can offer all these different things on the menu and let you pick and choose what it is you like. In the end, they fly you to Chicago (and your luggage to Minsk), and you get as nice a trip as you are willing to pay for.