Thursday, 14 September 2017

How airlines use extra charges to boost their profits

Grant Bradley wrote in the New Zealand Herald back in July:
Airline revenue from frequent flier schemes, charging for bags and food has grown more than 10 times in the past decade to nearly $40 billion.
A study of 10 airlines which are among the biggest ancillary earners show that in 2007 it generated US$2.1 billion ($2.87b).
Last year the top 10 tally has leapt to more than US$28 billion.
While base air fares are near historic lows, if passengers want extras they are increasingly being forced to pay for them, especially on budget carriers...
"Low cost carriers rely upon a la carte activity by aggressively seeking revenue from checked bags, assigned seats, and extra leg room seating. Some of the best in this category have extensive holiday package business with route structures built upon leisure destinations," the report says.
None of this should be terribly surprising. The airlines are making use of a simple business strategy that we discuss in ECON100: taking advantage of customer lock-in.

In the usual discussion of customer lock-in, customers become locked into buying from a particular seller if they find it difficult (costly) to change to an alternative seller once they have started purchasing a particular good or service. Switching costs (like contract termination fees) typically generate customer lock-in, because a high cost of switching can prevent customers from changing to substitute products.

In this case, once the airline customer has purchased a ticket from an airline, they are locked into travelling with that airline (and often, they are locked into a particular flight, if they have selected a ticket type that is non-transferable). The airline knows that the customer won't switch to another airline (or flight) if they charged additional fees for complementary services [*], such as for checked bags, in-flight meals, selecting their own seat, and so on.

This is a highly profitable proposition for the airlines (see Bradley's figures above), and this is because customer demand for those extra services is relatively inelastic. Once you have purchased a plane ticket for a given flight, there are few (if any) substitutes that allow you to get your checked baggage to the same destination as you are going. So your demand for checking a bag onto your own flight (if you have a bag that needs checking in) is probably very inelastic. Similarly, if you are not prepared for your flight and buy some snacks to take onto the plane with you (and/or you don't have a meal before boarding and are unwilling to wait until you land to eat), there are no substitutes to buying a meal while in the air. When there are few substitutes for a good or service, demand will be relatively more inelastic, and the optimal mark-up over marginal cost is high. As many of you will have observed, the mark-up on in-flight snacks and meals is very high. It is these high mark-ups that leads these extra charges to be highly profitable for the airlines.

While the extra charges have been increasing, ticket prices have been declining. Airlines can afford to lower ticket prices if they know they will more than make up for the lost profits on tickets with the additional profits from these extra charges. In fact, they could (and may yet) go as far as using economy-class tickets as a loss leading product! Economy-class tickets will be effective as a loss leader if demand for tickets is relatively elastic (so that lowering the price leads to a large increase in the number of ticket buyers), and where there are many close complements (so that the airline will sell a lot of the extra services, which are highly profitable). Both conditions appear to be being met, so airline economy-class ticket prices may have further to fall, but don't expect those extra charges to disappear any time soon.


[*] Note that this is complementary, meaning services that are consumed along with the airline ticket, and not complimentary, meaning free!

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