A different sort of post today. This one is about a research paper that Gady and I recently finished with our colleague Achal Bassamboo. The paper is called “Would the Social Planner Let Bags Fly Free?” It deals with ancillary services — things like checking bags or printing boarding passes that service firms provide in conjunction with their main service (i.e., flying a person in the case of an airline). What is notable about this paper is that it is the first paper to follow directly from this blog. In essence, the paper compare the relative merits of two quotes that have appeared here in The Operations Room.
The first quote is from Michael O’Leary, the CEO of Ryanair and it appeared in something Gady wrote. (It should be clear from this why we refer to this paper as Fee to Pee.)
Like, paying for checked-in bags: It wasn’t about getting revenue. It was about persuading people to change their travel behavior—to travel with carry-on luggage only. But that’s enabled us to move to 100% Web check-in. So we now don’t need check-in desks. We don’t need check-in staff. Passengers love it because they’ll never again get stuck in a Ryanair check-in queue. That helps us significantly lower airport and handling costs.
Now we’re looking at charging for toilets on board—not because we want revenue from toilet fees. We’d happily give the money away to some incontinent charity. What it means is, if by charging for toilets on board, more people would use the toilets in the terminals before or after flights, I could take out maybe two of the three toilets on board, add six extra seats and reduce fares across the aircraft by another three or four percent.
The second quote appeared in a post I wrote about Spirit Airlines starting to charge for printing boarding passes at the airport (which Ryanair was already doing). It is from Ben Baldanza, Spirit’s CEO.
“We believe it is important to let customers decide what is of value to them,” said Ben Baldanza, Spirit’s chief executive. “Imagine if you went to a restaurant and all the meals came with dessert. That’s great if you like dessert but, if you don’t, you would prefer the option to pay less for the meal and not take the dessert.”
Note that these are fundamentally different rationales. Ryanair’s O’Leary is saying fees are shaping behavior to lower costs and those saving can be shared with customers. Spirit’s Baldanza is basically talking about segmentation. He’s creating a pricing menu that may give some customers a break but is mostly going to extract extra cash from customers who value or need ancillary services.
So do either of these explanations hold water?
For that we need a model. Suppose that customers have some value for the main service (e.g., $300 to fly from Chicago to New York) but don’t have a separate value for the ancillary service but will use it if needed. Ryanair’s proposed lavatory charge fits this. If you are flying with a four-year old and he says he needs to use the restroom, forking over a euro is much cheaper than playing wet-pants roulette.
Our model also supposes that customers can exert effort that reduces the chance of needing the service (e.g., dragging the four-year old to the airport restroom before the flight). That effort is costly and may not completely eliminate needing the ancillary service. (For those who have never flown with a four-year old, take my word for it that the model reflects reality.) Finally, suppose that providing the ancillary service is costly to the firm.
Let’s start with O’Leary’s claim. First, we can show that it is optimal from a societal point of view to have customers put in some effort. That is, if there were a social planner who could make decision to maximize societal welfare, she would make customers put in some effort — enough to balance the rate at which customer costs increase with the rate at which the firm’s cost decrease.
Now for the airline’s problem. If it bundles and includes the ancillary service with price of the main service, customers put in no effort and the firm spends a lot on providing the ancillary service. If instead it charges separately for the ancillary service, customers put in effort and, as O’Leary claims, the cost of providing the service falls. The cool thing is that the ancillary service fee it chooses induces the same effort that the social planner would choose. That is, profit maximization leads to the effort level that is best from a societal point of view. Further, if customers have different values for the main service, the airline lowers the total cost customers incur and more people fly.
In a nutshell, baggage fees make the world a better place.
OK, onto Baldanza’s segmentation story. We need two sets of customers (just like he assumes that one set of customers want dessert and another doesn’t). Let’s suppose that there is a low cost segment and high cost segment. If a high cost customer and a low cost customer put in the same effort, then the high cost customer is more likely to need the ancillary service. The firm cannot tell the customers apart just by looking at them. It’s going to post two contracts and see who picks what.
So what contracts does it post? The contract for the low cost segment includes a high ancillary service fee and a relatively low price for the main service. (Actually, the ancillary service fee is what the firm would charge if they were the only segment.) The contract for the high cost segment has low ancillary service and a high price on the main service. The firm may, in fact, bundle the two services for the high cost segment. Intuitively, the firm makes more money on the low cost segment and tries to extract as much from them as possible. But that means it has to make picking the wrong contract undesirable. It can do that by charging high cost customers a lot for the main service and they are willing to pay it because they get a break on the ancillary service. The low cost customers don’t value the ancillary service discount that much because they are unlikely to use the ancillary service.
If we look at baggage fees, this means that road warrior business travelers who can easily live out of a carry on for a week should pay more for a checked bag than an infrequent traveler going on vacation. That clearly isn’t what we see in the market place. If anything, we see high status frequent fliers getting a free pass on checking bags. The conclusion then is that to the extent that airlines segment customers (and they clearly do), they are not doing it along the lines of the need to check bags.
Two caveats to all this are worth noting. First, there are many sources of airline ancillary revenue that do fit the Baldanza segmentation paradigm. Consider United’s charging for extra leg room or many airlines programs that let you jump to the front of the security line. Those are clearly about getting more out of the long-legged or the time-pressed.
Second, we cannot assert that current baggage fees are socially efficient because other market factors come into play. Or to be more blunt, the government mucks it up. The US charges an excise tax on tickets (our main service) but not on ancillary revenue. We show that this gives firms an incentive to distort its pricing and shift revenue to ancillary fees.