The economics of reclining airline seats

The problem of reclining airline seats and the related fights between passengers was a big thing in the media in 2014 (see here and here), but has been back in the media recently. The Economist's Gulliver blog had an excellent piece earlier this month entitled "Who owns the space between reclining airline seats?". It's an interesting read, and highlights several things we discuss in ECON100 and/or ECON110, including: (1) externalities and the Coase theorem; and (2) quasi-rationality and endowment effects.

If Person A (who is sitting in front of Person B) reclines their seat, they reduce the amount of space available to Person B. This is a negative externality (an adverse impact of one person's actions on the wellbeing of a bystander). There are a few things we can take away from this example. First, as Coase originally noted, externality problems are jointly produced by the person who creates the externality and the person who is affected by it. If no one was sitting in Person B's seat, then there would be no externality problem. The externality problem only exists because of both passengers' actions (Person A reclining their seat, and Person B sitting in the seat behind). [*]

Second, the polluter pays principle is not always the best solution to an externality problem. The polluter pays principle essentially says that the polluter (in this case, Person A) is always at fault any must avoid the actions that affect the other party (by not reclining their seat), or pay them compensation. If we believed the polluter pays principle is the best solution in this case, no one would be allowed to recline their seat.

In contrast, the Coase theorem suggests that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own (i.e. without any government or other intervention). As Gulliver notes:

According to the theories of Ronald Coase, who won the Nobel Prize in Economics in 1991, the space between airline seats is a scarce resource. Therefore it should not matter who has the initial ownership (assuming there are no barriers to a deal being made). The market will out: whoever values the space more will buy it from the other. (In this case it would normally revert to the recliner.)

What happens if we allow passengers to make these bargaining solutions? We really don't know, as no airline has ever tried it (as far as I know). However, Gulliver writes:

Would such fights be prevented if ownership of those four inches were up for auction? This was the starting point of an experiment by Christopher Buccafusco and Christopher Jon Sprigman, two law professors, which they have written up on the Evonomics website. 

Their aim was to discover whether recliners’ pleasure at being more horizontal is greater than the amount of suffering this inflicts on the person behind. One obvious way to do this is to put a monetary value on it: find out how much the flyer in front would be willing to pay for the right to recline his seat, and compare that with the amount the person behind would be prepared to shell out to stop this from happening. 

In an online survey the researchers asked people to imagine that they were about to take a six-hour flight from New York to Los Angeles. Respondents were told that the airline had created a new policy that would allow flyers to pay those seated in front of them not to recline their seats. Some were then asked how much the passenger behind would have to pay them not to recline during the flight. Others had to specify how much they would be prepared to pay to prevent the person in front of them from reclining.

I suggest reading up the Evonomics article by Buccafusco (Cardozo School of Law) and Sprigman (NYU School of Law), as there is lots of interest there. Note that it is a stated preference study - we don't know for sure what people would actually do when faced with these choices, but this is what they said they would do:

Recliners wanted on average $41 to refrain from reclining, while reclinees were willing to pay only $18 on average. Only about 21 percent of the time would ownership of the 4 inches change hands...

That sounds fine, and was based on the current default set of property rights - that people have the right to recline their seat. But then things got interesting:

When we flipped the default—that is, when we made the rule that people did not have an automatic right to recline, but would have to negotiate to get it—then people’s values suddenly reversed. Now, recliners were only willing to pay about $12 to recline while reclinees were unwilling to sell their knee room for less than $39. Recliners would have ended up purchasing the right to recline only about 28 percent of the time—the same right that they valued so highly in the other condition.

So, when people had the right to recline their seat, they wanted $41 to give it up. But, if they didn't have the right, they were only willing to pay $12 for that right. If that seems odd to you, then welcome to the world of behavioural economics. The Coase theorem suggests that the initial allocation of rights should not matter, because if the person who values the right the most doesn't start out with it, they will simply purchase it from the other. But what Buccafusco and Sprigman found suggests that this simple solution might not work. What they found was an endowment effect.

Because people are loss averse, losses make us much less happy than an equivalent gain makes us happier. For example, losing $10 is more bad news than finding $10 is good news. One of the consequences of this is that we are unwilling to give up something that we already have - we require more in compensation to give it up than what we would have been willing to pay to obtain it in the first place (this is what we call an endowment effect). Note that endowment effects are working for the 'reclinees' as well - they are willing to give up their extra knee room for $39 if they had the right to keep it, but would only be willing to pay $18 to get that right if they didn't start out with it.

The endowment effect means that this problem isn't really amenable to a simple solution, because recliners already have the default rights, and are understandably unwilling to give those rights up. And any change in policy is going to incur passenger protest - because even though we may gain knee room, passengers would be giving up their right to recline, and loss aversion almost ensures that would be a painful and unwelcome trade-off for most passengers.

*****

[*] Of course, Person B probably has little choice about where they are seated. But, there are plenty of other examples of externalities where there would be no problem if the affected person was simply somewhere else. One example I've blogged about before is people who choose to live next to mushroom farms.

Return migrants to Vietnam prefer areas with higher-quality institutions

One of the enduring theories of migration is the push-pull theory of Everett Lee (see here for the original research paper from 1966). In this theory, there are factors in the origin (where the migrants are coming from) that push them away, and factors in the destination (where the migrants go to) that pull them there. Many factors might be push or pull factors, including high (or low) wages, or good (or bad) amenities. As I discussed in a previous post, climate is one factor that appears to affect migration, but only in a very limited way.

In a new working paper, Ngoc Tran, Jacques Poot and I look at return migration to Vietnam (this is where Vietnamese migrants have first migrated overseas, then return home to Vietnam), and specifically whether the location that return migrants return to is influenced by the quality of political and economic institutions (in economics, the term 'institutions' is used to refer to social and legal norms and rules). This question is important because there are generally few factors that policy makers can use to influence people's migration decisions, but the quality of institutions is generally something that is within their control. So, if they want to attract return migrants (or potentially other migrants), then having high quality institutions is important.

We used a database of the return migration choices of 654 Vietnamese return migrants to the south of Vietnam in 2014, including the province that they eventually settled in. We found that, holding other variables constant, older return migrants and male migrants were less likely to settle in Ho Chi Minh City (and more likely to return to other regions). Once we introduce the 'provincial competitiveness index' (a measure of local institutional quality in Vietnam) into the model, we find that return migrants are more likely to return to a region with higher-quality institutions.

Digging a bit deeper into the results, we find that this preference for higher-quality institutions depends on the age of the return migrant, with younger return migrants displaying a greater preference for higher-quality institutions than older return migrants. Also, migrants who returned from a country that itself has higher-quality institutions revealed a greater preference for higher-quality institutions when they returned to Vietnam (though this result was not nearly as statistically significant). These results are interesting, especially the latter result, which suggests that there are spillover effects of developing country migrants adopting expectations of high-quality institutions back home, that are similar to those they experienced in the host (usually developed) country. The results also suggest that better institutional quality may attract return migrants, especially those who are younger (and have greater remaining productivity and reproductive potential). Perhaps there might be some lessons to be learned in this for declining regions in other countries?

Finally, this paper is also the first research paper from Ngoc's PhD thesis, so congratulations to her on that achievement, and I look forward to reporting on her future work in later posts.

Free trade agreements, or international commerce agreements

Last week in ECON100, we covered the gains from trade. One of the points I made was the misnaming of free trade agreements, which these days are mostly not about free trade. This was a point made recently by Bill Rosenberg (economist for the Council of Trade Unions) in the New Zealand Herald:

But these agreements are no longer mainly about trade. It is misleading to talk about them as Free Trade Agreements. I'll call them international commerce agreements, and it is misleading to label public concerns as protectionism.

These agreements are now mainly about services, regulation (including so-called non-tariff measures), foreign investment, intellectual property, government procurement, commercialisation of public agencies, and other matters that are "behind the border" and cut deeply into people's daily lives. That is why people protest at restrictions on the ability of future Governments to make and change rules in the public interest, to adapt to new circumstances and repair poor policy of the past.

I like Rosenberg's characterisation of these agreements as 'international commerce agreements', and might start using that terminology interchangeably with 'free trade agreements' in my classes. Not everyone gets this, as this response to Rosenberg from Mike Hosking demonstrated.

It's hard to argue against free trade in itself (though such arguments continue to be made - see my earlier post on this), especially if genuine attempts are made to compensate the losers from free trade (such as those who lose jobs in industries in which we have a comparative disadvantage). There are certainly enough gains for the winners from free trade to compensate the losers, and have some extra left over. However, whether an international commerce agreement (or free trade agreement, if you prefer) has a net positive effect depends on how you evaluate the costs (or benefits) to the economy from all of the other non-free-trade-related clauses in the agreement. And that cost-benefit evaluation is enormously tricky - the more elements you include, the harder the evaluation is going to be.

The economic evaluation of the Trans-Pacific Partnership agreement was conducted by my colleague Anna Strutt and others (you can read the full report here). That economic evaluation estimated gains for New Zealand of $624 billion by 2030 from tariff liberalisation alone, and $4.16 billion if liberalisation of non-tariff trade barriers and customs delays were included. But note that this is trade-related gains only, and doesn't consider all of the other parts of the agreement, such as intellectual property, changes to Pharmac, etc. And now that the US is not included, you can expect the trade-related gains to be somewhat less.

Overall, I'll remain pro-free-trade, but agnostic on free trade agreements.

Three reasons why tipping is a bad idea

Tipping has been in the news this week. Matt Heath started it with this article on Sunday, but then Deputy Prime Minister (and former waitress) Paula Bennett chimed in, saying "Overall I think the service in New Zealand is good, I always tip for excellent service and encourage others to too if we want standards to continue to improve" (at least, according to this article - I didn't read her letter to the Herald myself). Bennett's comments have stirred a lot of media interest (see here and here and here, for example). Now, as the voice of reason, I give you three reasons why tipping is a bad idea.

First, it's not rational if it's not already a social convention. To see why, we need to go through a little bit of game theory (which is good revision for my ECON100 students, since we did game theory in class last week). Consider a sequential game with two players: (1) the server, who can choose to give average service, or good service; and (2) the customer, who can choose to tip, or not, and makes their choice after the service decision of the server has already been revealed. Let's say that the basic outcome (average service and no tip) leads to a zero payoff for both players. Let's also assume that if the server gives good service, that increases the payoff to the customer by +6 (units of utility, or satisfaction), but comes at a cost to the server of -2 (units of utility). Finally, let's assume that if the customer chooses to tip, that reduces their payoff by 5, and increases the server's payoff by 5. The game is laid out in tree form (extensive form) below.

To find the subgame perfect Nash equilibrium here, we can use backward induction (similar to the best response method we use in a simultaneous game). Essentially, we work out what the second player (the customer) will do first, and then use that to work out what the first player (the server) will do. In this case, if the server gives good service, then we are moving down the left branch of the tree. The best option for the customer in that case is not to tip (since a payoff of +6 is better than a payoff of +1). So, the server knows that if they give good service, the customer is better off not tipping. Now, if the server gives average service, then we are moving down the right branch of the tree. The best option for the customer in that case is not to tip (since a payoff of 0 is better than a payoff of -5). So, the server knows that if they give average service, the customer is better off not tipping. Notice that the customer is better off not tipping no matter what the server does - not tipping is a dominant strategy for the customer. So, the choice for the server is to give good service (and receive a payoff of -2) or to give average service (and receive a payoff of 0). Of course, they will give average service. The subgame perfect Nash equilibrium here is that the server gives average service, and the customer doesn't leave a tip.

However, that analysis assumes that this is a non-repeated game. We know that if games are repeated, the outcome may be able to move away from the Nash equilibrium to an outcome that is better for all players (notice that the combination of good service and tipping is better for both players). How do we get to this alternative outcome? It relies on cooperation between the two players, and cooperation requires trust. The server has to trust that the customer will tip them, before they will agree to give good service. Can they trust the customer? Only if they have developed a relationship with that customer, and in most hospitality situations it is unlikely that a customer will encounter the same server again in the future (unless they are a regular). So, no trust. No cooperation. No tipping, and no good service.

Which brings me to social convention. One way to ensure cooperation from the customer is to make tipping a social convention, which has some social penalty attached to it. If it is frowned upon not to tip the server, to the extent that it becomes costly (in terms of moral costs or social costs, not financial costs) not to tip, then that changes the game. Say that the moral cost of not tipping is -6 units to the customer (since everyone who sees them not tipping the server then thinks the customer is a douchebag). This changes the game to this:

Now, where is the subgame perfect Nash equilibrium? If the server gives good service, the customer will tip (because +1 is better than 0). If the server gives average service, the customer will tip (because -5 is better than -6). Notice that tipping is now a dominant strategy for the customer. Knowing what the customer will do, the server will choose to give average service (since +5 is better than +3). The subgame perfect Nash equilibrium is now that the server gives average service, and the customer leaves a tip. We might wish that tipping would provide servers with an incentive to give good service, but that isn't always the case!

Nevertheless, tipping relies on a social convention, which is not the current convention in New Zealand. And developing new social conventions is not easy (although perhaps Paula Bennett is willing to give it a try in this case?).

The second reason why tipping is a bad idea is because of second-order effects. If customers have to tip the servers, this increases the cost of their meal. Since we know that demand curves are downward sloping, an increase in price will lead to lower quantity demanded - customers will demand fewer restaurant meals. If you doubt this point, then consider how many people you know (I'm sure there are at least some) who object to paying a surcharge for a meal on a public holiday, and so choose to either eat somewhere else (where there is no surcharge) or not to go out at all. Now, note that tipping is essentially the same as applying a surcharge to every restaurant meal.

Since the quantity of restaurant meals demanded will decrease, the number of servers required by restaurants also decreases. Tipping will make some servers better off (higher take-home pay), but will make others worse off (they no longer have a job). This has the same effect as raising the minimum wage, except the customers are paying the extra, rather than the employers. I'm not sure that's a trade-off that customers should be willing to accept.

The third reason why tipping is a bad idea is because it could be considered a form of corruption. If you doubt that, consider this example. Remember that the purpose of tipping is to reward the recipient for giving good service. Now, say that I'm pulled over by a police officer for driving through a stop sign, but the officer decides to let me off with a warning (seems unlikely, but let's run with it). The officer gave me good service - should I tip them?

The World Bank defines corruption as:

...the offering, giving, receiving or soliciting, directly or indirectly, anything of value to influence improperly the actions of another party.

Isn't tipping to reward good service providing something of value (money) to influence the actions of another party (to give you good service)? We could quibble over whether the influence is improper or not, I guess. But the general point is valid.

Anyway, now you have three reasons to use to explain why you shouldn't be tipping: (1) it's not rational (when there is no social convention for tipping); (2) it may make some servers worse off; and (3) it may be corrupt. You're welcome.