Annals of commerce: Do airline companies know what they’re doing?

What’s wrong with this picture, retailed in The Economist [sic] from an air traveler web site where the discussion has some sensible observations about seat pricing?  Right: the seat with no legroom, and the original seat with some legroom, are treated as though they are the same good that will sell for the same price, even as the seat with extra legroom is credited with a higher price.  If markets work, the squooshed seat has to sell for less than the standard seat.  In Patrons Despite Themselves, we examined resale royalties laws that obliged art collectors to pay artists a fraction of any appreciation a painting experienced after they (collectors) bought it.  Artists lobbied hard for this nonsensical piece of policy, because they couldn’t see that when the dust cleared, collectors must pay less for “Sunset less 15% of its appreciation after purchase” than for Sunset in fee simple, and that the real effect of the law, even leaving aside the nuisance of keeping track of your work after you sell it, is to transfer risk from (rich) collectors to (poor) artists and money the other way, something no-one would knowingly advocate as abstract goals.  It’s the same mistake, subconsciously treating both deals as though they involved the same thing.

Do markets work? Of course, but not always and not the way the examples in chapter 1 work.  Economics begins with mythical creatures modeled as Economic Man (and his sister Sue) and Profit-maximizing Firm.  There’s a lot of insight to be drawn from this cast, but no economist I know thinks real people are like that; the interesting stuff happens when we think about all the standard market failures and the real psychology of human decisionmaking.  What’s really going on with the airline seats?  To understand this, we have to look at how airline ‘seats’ are actually sold, and at the history of the industry. Most people start their search for air travel at a web site that presents options whose descriptors are an origin and destination, a schedule, and a price. (First class and business class seats are elements of an almost completely separate market.)  There’s nothing about food, seat pitch (legroom), seat width, warmth of FA smile, or movie on offer. This information is available with some effort, but as few passengers bother to look, the cheap seat gets the traveler and airlines have pretty much stopped competing on any of the other product qualities except to reward repeat buyers, and to unbundle separable services like checking a bag.

The tradition of “just selling a seat” originated when fares were regulated by governments, mostly to protect weak firms in the business, and load factors (percentage of seats sold) were much lower than today; adding seats to an airplane didn’t add much revenue.  It used to be a good bet on a transatlantic flight in the winter that you could appropriate all four or five center seats in coach, flip up the armrests, and lie down. At that time, airlines competed by lobbying the CAA and congress for fares, routes (what TWA had and Pan Am couldn’t ever get was domestic routes to connect with and feed its international flights) and in-flight comforts. At one time transatlantic carriers decided to limit their offerings of better and better meals, which was becoming a positional arms race no-one could win, by allowing only “sandwiches” in coach.  This produced the late lamented “sandwich wars” in which commissary chefs competed to see how much of a three-course meal they could load onto a piece of bread.

With deregulation, the industry entered a new world, but with an executive corps habituated to the rules and coddling of the old one.  I believe the persistent organizational culture of airlines is one reason they are so bad at what they do now, and why an industry with such wonderful technology has not made a penny of net profit since the Wright Brothers (admittedly, government management of national airlines over decades for purposes other than carrying people about  had a lot to do with this).  Look again at that seat diagram: the extra legroom seat is now regularly sold for a premium price on many airlines…but why isn’t it listed as a separate class right on the booking web page with the other options?

More puzzling is their failure to recognize or at least experiment with a business market that isn’t traveling to party.  On most wide-body aircraft, seven international business class seats take up about the same cabin floor space as 18 coach seats. So the airline should be indifferent between selling coach seats for $C and business seats for 18/7 x C, a little more than twice as much.  Instead, they charge five to six times as much for business. For the $1150 SFO-FRA RT itinerary I just looked at on United, this should be about $3000, but the business fare is $5600 or $6200.  What’s the extra two-and-a-half large for?

Let’s break down the pieces of these goods.  In coach, you get a couple of paper plates of swill, free soft drinks, a pillow and a sort of a blanket, a couple of movies, and ten miserable hours during which you can neither sleep nor work, with a small chance of a fatal blood clot forming in your legs.  Checking a second bag costs extra, and should (though I’m not sure the prices make sense).  In business, you get access to the airport lounge on departure, an imitation of a restaurant meal served on real dishes and a cloth napkin, all you can eat of nuts and snacks, free drinks, slippers and an eyeshade, a better chance of getting your carryon into the overhead storage, a choice of movies, and a lot of fussing over from the FAs.  You also get a power outlet and a seat you can actually sleep in (going) and work in (coming home), and at least two free checked bags (note that this last item is better described as, you get to pay the average cost of checked bags whether or not you have one).

The space is covered in our notional $3000 price that would make the revenue from one business row equal two coach rows’; what is the rest of the business package worth?  I can’t make it more than $100, drinks and all, though at that price I would instead buy a nice sandwich in the airport for $10, travel with a bag of trail mix, and just pound on-board orange juice.  I have no interest in drinking alcohol when I’m already fighting dehydration and facing a nine-hour time change. What I care about is the space and the outlet, period, and I bet I’m not alone.

What’s in it for the airline to trade 18 coach seats for seven no-frills business? A lot: eleven fewer  ticket sales and processing, eleven fewer bags to wrangle, and about a ton less of passengers to keep aloft (aviation cost is all about weight, especially with high fuel prices). United charges $100 for the second bag on that route, so if that’s close to right, the business seats save the airline $1100 for eleven fewer bags alone.  All in all, if the airline could sell seven business seats with coach-grade frills at $3000 each instead of 18 coach seats at $1150, it would be coining money and should be converting two rows of coach to one row of business right down the aisle.

Most businesses are very stingy about buying business class seats, understandably at the prices on offer, so the cabin is only a quarter business.  What might justify an $1800 basic-business premium, instead of $4400, on that route?  It’s 22 hours of flying, or more than half a working week, during which you can sleep or work; in a coach seat that time is lost (if you can’t sleep at night, your next day is a total loss and the one after that is no picnic if you’re also dealing with jetlag).  It’s also more productivity at the destination, because you’re not an exhausted wreck stepping into your hotel room in the morning.  A lot of people are worth $80/hour, not so many $200; there is a market for business-class travel shorn of silly frills, and sold at a price that’s much more profitable than the same square footage of cabin in coach. But the airlines can’t see it, because they won’t make it available.

Why is this so hard for airline managers – who have finally figured it out comparing profit from equivalent areas of steerage and economy plus – to understand?

 

Comments

  1. Jonathan Monroe says

    Both British Airways and Virgin Atlantic have premium economy available on their long-haul routes. On Virgin Atlantic this is a genuine premium service (the seat and service levels are similar to intra-European first class). On British Airways you get an extra 9 inches of legroom, a full-width armrest, and not much else. I slept (fitfully) in Virgin premium economy from SFO to LHR – I have never slept in coach. The fare is typically about 1.6 times coach for about 1.3 times the cabin space.

    I believe some Asian airlines have done the same thing as well.

  2. Warren Terra says

    I don’t know if “sleep” is the right word – it’s not tremendously restful – but I’m able to doze reasonably effectively in Coach, deplaning no more tired than I boarded. It’s unpleasant, and the time is effectively lost, but it does work.

  3. JohnTh says

    Premium economy class on some international carriers makes a nod in this direction – less space than business but more than in economy/coach and a few extra service tweaks at a 50-100% mark up to economy prices. As a 6-and-a-half-footer the creation of this class has more or less made long distance air travel possible for me (more than 4 hours in economy are unbearable, although the possibility to reserve the exit seats also helps nowadays).

    • says

      Perhaps you could qualify as situationally disabled – that is, unable to fold yourself into tiny spaces?

      Though I don’t know that airlines make nice provisions for people who are too wide for seats, either.

      I’m 6’1″, and prefer trains (though not for transatlantic travel).

  4. Anomalous says

    Pricing, particularly for premium services and products is not a function of rational calculation once the price gets above the break even level. Prices are set by what the market will bear. If the airline could double their price and put 75% as many rears in seats they would do that. So would you.

  5. Cranky Observer says

    = = = here’s a lot of insight to be drawn from this cast, but no economist I know thinks real people are like that; the interesting stuff happens when we think about all the standard market failures and the real psychology of human decisionmaking. = = =

    And yet you write a long and very through post without really analyzing the fact that people in airline seats talk to each other and compare their ticket prices, and that Bob Crandall [1] “value pricing” – which results in seat neighbors having paid $150 and $1500 for the same journey – absolutely insane with hatred for the airline. And eventually drives them into the arms of Southewest, Ryanair, etc. Nor to Joe and Jane Realperson accept that there is a 10:1 difference in “value” (during the dotcom days, often 20:1 or even more) between a ticket purchased 21 days ago and one purchased 13 days ago. Economists and airline pricers think there is; customers not so convinced.

    Cranky

    By the way, Crandall introduced this type of discriminatory pricing almost 30 years ago so I’m not sure why you think it isn’t used. There is also a cost/benefit analysis required on the worth of complixifying the ticketing software and seating chart beyond a certain point.

  6. Allen K. says

    I love your posts, professor, but this particular one is not reality-based. Airline seat pricing is about differential pricing, not about what’s on offer. A clue is provided by the fact you mention that the sum total of airline profit is zero.

    Here’s a story gleaned from Andrew Odlyzko’s writings on the history of differential pricing (he writes on many topics; ^F for “pric” in the list linked). About 160 years ago, passenger railway trains would have a bunch of covered cars, and a bunch of open-air cars which would receive cinders and ashes in their riders’ faces. It would have been cheap to cover those cars; but then the riders in the covered cars wouldn’t have spent the surcharge to avoid sitting in them.

    (Now consider that competition between railways was pretty efficient. The effect was that the people in the cheap seats were paying less, in money, than the actual cost of transporting them; this cost was being subsidized by the people in the expensive seats. It’s a somewhat progressive system if you think about it, making things available to people without money, by giving alternative currencies for them to pay with.)

  7. Micromeme says

    You seem to have skipped over the fact that business travel is not paid for by the buyer/ flyer. But by their companies… The pricing is totally geared to get extra through that agent problem. Seems a rather half baked analysis complete with a perhaps unwarranted assumption that a lot of internal analysts and computer time are all stupider than you are. Its true that the airlines have problems but its not really so obvious that lack of pricing schemes and yield management is one of the big ones

  8. Keith Humphreys says

    Mike wrote: “Instead, they charge five to six times as much for business.”

    I wonder if, like health care prices and tuition prices, premium class seat prices do not generally reflect what people are charged. I have flown international first class from London to San Francisco for $199 (allegedly, a $10,000 ticket — I bought a crummy coach seat, used an coupon to upgrade to business, and then at the airport they put me in first because they had space and I fly a lot). I fly long haul business class about 5 times a year using coach tickets (free upgrade for a frequent flier). American Airlines has a “Business special” product, which is the same business seat as in business but is priced 40-60% less and carries some restrictions in terms of re-ticketing in the event of a schedule change (which even if you change tickets is not going to cost you anywhere near another 40%).

  9. JMG says

    Shorter: managers and “job creators” paid absurd amounts of money in government subsidies think they’re a lot smarter than they really are, even though the only thing they actually know how to do well is grease their way through life so that they can plunder their employers and then game the bankruptcy laws to break their union contracts, take it out of workers hides’, rinse and repeat.

    All while having a hugely disproportionate and negative effect on climate disrupting emissions.

    Mass air travel to ferry people to vacations will be our Easter Island megaliths. Archeologists of the future will scarcely believe that we could have squandered so much wealth on an activity that served only to destroy the resource base our lives depended on.

  10. Davis X. Machina says

    …we examined resale royalties laws that obliged art collectors to pay artists a fraction of any appreciation a painting experienced after they (collectors) bought it.

    This model is borrowed from soccer/football, where the sell-on fee is a fact of life. Come to think of it, a lot of the art market looks like football….

  11. Byomtov says

    Artists lobbied hard for this nonsensical piece of policy, because they couldn’t see that when the dust cleared, collectors must pay less for “Sunset less 15% of its appreciation after purchase” than for Sunset in fee simple, and that the real effect of the law, even leaving aside the nuisance of keeping track of your work after you sell it, is to transfer risk from (rich) collectors to (poor) artists and money the other way, something no-one would knowingly advocate as abstract goals.

    I don’t think it’s as simple as all that. First, the artists’ have a one-sided payoff – they don’t have to give the money back if there is no resale. That complicates the risk picture, I think. Second, if the dealer is more knowledgeable about the resale market than the artist this reduces the effects of that asymmetry.

    Maybe all that washes out, but I’m not sure.

    • Michael O'Hare says

      give what money back? the painting sells for (say) $1000 free and clear, $900 with resale royalty. The artist is betting $100 that the painting will increase in value by $100/15% = $667 or more: more risk for him, and less money. This doesn’t apply to dealers, who usually make the first sale on commission (don’t take ownership of the work), but to collectors. If this were a good deal for artists, they would routinely withhold one out of every six works they make from sale, but they don’t (unless they’re already rich): they sell everything they can.

      • Byomtov says

        The artist is betting $100 that the painting will increase in value by $100/15% = $667 or more: more risk for him, and less money.

        OK. And that’s right for one painting, though the probability of winning the bet is not irrelevant.

        But isn’t the effect on the artist’s total sales ambiguous?

        And just as the artist could withhold one painting in six, couldn’t the collector who hates the law buy seven instead of six?

        • tsts says

          “And just as the artist could withhold one painting in six, couldn’t the collector who hates the law buy seven instead of six?

          Assuming 7 are available. This is where it gets complicated. Should we assume that the supply of paintings by artist X is fixed — limited by the inspiration and creativity of the artist? Will the supply of paintings that are actually on the market increase with lower prices because the artist (who loves her paintings and would prefer to keep them) has to sell more of them to survive? Or will lower prices result in the artist being less motivated and slacking off or going Galt?

          Not saying the royalty laws are a good idea or not. Just that things are more complicated. Only a fool — or possibly an economist — could conclude otherwise.

          • Byomtov says

            Assuming 7 are available.

            Well, yes. But I was writing abstractly. It could mean buying seven instead of six from a variety of artists, for the same outlay and return and initial payment to artists as under the royalty scheme.

      • tsts says

        Agree with Byomtov that it is not as simple as that, though maybe for different reasons.

        First, this law might make it more likely that paintings are bought by collectors who intend to keep it than by investors, since it basically punishes resales. A collector who intends to keep it has no reason to pay less for the painting with the 15% resale royalty. And that painting will stay off the market, restricting supply. (And I assume there is some sunset clause such that after a certain time, or if the artist dies, there is no payment? Reminds me of the flip taxes in some NYC coops that discourage investors.)

        Concerning your argument that artists might withhold one out of six works: yes, they could. But sometimes it might be good policy for force people to do so, which is what the 15% resale royalty achieves. For example, many countries force people to provide for their retirement, and I suspect that is good policy. But your argument seems to be that this is irrational?

        • John R Walker says

          I am a professional visual artist.

          All round the world Art resales, by value, are very skewed to the top 100 best selling artists- 70% of whom are dead. In the first years of the UKs scheme 49% of the total value of royalties was paid to just 20 individual artists. As a superannuation scheme resale royalties are bizarre nonsense.

          As for holding stuff back, artists who have sales (and thus the chance of resales) have always held back a percentage of their favorite artworks.

          The harm caused to artists by resale royalties takes the form of what doesn’t happen, and therefore the harm done is easy to underestimate. When an artist, like me, sells a work for $10,000, I pay $4,000 to the costs of sales and marketing (through my representative agent) and retain $6,000 as income. In the case of a $10,000 resale, I would receive $500 (minus costs). If buyer nervousness about the resale royalty was to cause me to lose just one $10,000 first sale buyer, I would need the royalty payable on a total of $120,000 of future resales, just to recoup the lost income of that one primary market buyer.

  12. robinia says

    Re “discriminatory” and “it’s not my fault” — how much space you occupy (or wish to occupy) is not a blame game; it’s a simple matter of fact that some people fit into spaces that others do not. One of my more memorable flights was with a very large seat mate. It was physically impossible to put down the armrest between us, and there were no extra seats on this flight; thus I spent most of it happily standing at the back of the plane and chatting with the the crew, who were sympathetic to my plight and encouraged me to write to the airline. So I did. Again, I LIKED being able to spend so much time out of my seat, and I didn’t harbor any personal feeling against the lady who was preventing me from full use of it. But damnit, I had purchased a seat ticket . . .

  13. Finn says

    Markets work because they are defined to do so. If you want to say that markets do X, then you have a big problem.

  14. Exiled Antipodean says

    Keith is probably onto something. The list price for a business or premium economy seat is often discounted to large corporates by a substantial amount. Add to that, on UA and AA the systemwide upgrades (global premier upgrades on UA now) mean that people are really paying some higher economy fare to get the fare class required to upgrade, and you probably get business class fares, on average, quite a way below the price you get quoted online.

    Normal economy class is like sleeping in a tent on the side of a mountain. United’s Economy Plus improves that to sleeping on the side of a hill. Premium Economy, still a tent, but maybe just a little bit of a slope. Business class is like a youth hostel, you get a bed, but a lot of people around you making noise, and the food isn’t great. I have no idea about First class, but my prior is that you’re still sleeping in an open space with strangers at an effective altitude of 7-8000 feet and crossing a lot of time zones. It’s never going to be a lark.

  15. Byomtov says

    All in all, if the airline could sell seven business seats with coach-grade frills at $3000 each instead of 18 coach seats at $1150, it would be coining money and should be converting two rows of coach to one row of business right down the aisle.

    But then no one would pay $5600.

    • H says

      A nice analysis of a fictional situation.

      In the real world almost no one is paying list price to fly in business or first class–actual figures are, of course, a highly guarded secret.

      Instead, they have a corporate negotiated price or a special price through a travel service or use upgrades and frequent flyer miles or buy through an ethnic travel agency that markets in, say, Thai or Hebrew.

      For example, I have a friend who regularly flies from L.A. to Tel Aviv in business. The list price is around between $4 to 8 thousand dollars depending on date (from UAL and El Al websites). He pays $2500 to $3000 roundtrip by buying through an ethnic oriented agent.

      And, I know many, including yours truly, who fly in the front of the plane for maybe a hundred bucks or so in taxes to go, say, LAX-Tokyo round trip.

      Me, I wonder if, in the end, using a subway pricing model (such as the old NYC token system) might not work out better for all concerned. Buy your tickets a month in advance or when boarding, all the same. It would help eliminate the essentially wasted vast effort put into looking for the lowest fare in an insanely complex system.

      • Byomtov says

        While I’m a touch skeptical of your “couple of hundred bucks” claim, unless you’re talking about always getting frequent flyer tickets – quite a trick – I do agree that many busines class passengers are there on upgrades.

        What that means is that many of those seats have been sold for much less than full fare – maybe something on average close to Michael’s $3000 – but there are still a few passengers willing to pay full freight. So the whole scheme makes some sense. Sell as many $5600 tickets as you can, and then allocate the rest to frequent flyers or other discount schemes. Note that the airlines do in fact constantly adjust the number of upgrades available on a flight, presumably as their models adjust the number of full-fare passengers expected.

        They do understand price discrimination.

        • H says

          Byomtov,

          Your skepticism is well found. I left out the hundred thousand or so frequent flier miles I meant to add. Oh, for an edit function on this blog!

          Nonetheless, almost no one is paying anything close to list for business or first tickets.

  16. says

    “no-frills business”: let’s say, Democrat business as against Republican business.
    Being retired, I always fly coach, and the airlines always supply eyeshades.
    My prophylactic against deep-vein thrombosis is to jog in the wider bit of the aisle near the loos. I get strange looks, but stay alive.
    On superjumbos, the airlines should put in a light exercise space and a library, not a shop or bar.

  17. Marc says

    This analysis misses the point, as did a similar article by Drum. Business travelers pay substantially more for full-fare or flexible tickets than budget-conscious vacation travelers do. The first-class seats are status rewards to encourage repeat business from people who buy expensive plane tickets frequently.

    There is also such a thing as minimum standards that we should tolerate in exchange for public goods (air traffic control, airport infrastructure, TSA, etc.) Frills (alcohol, multiple bags) are different from basics (liquids, sufficient space to avoid medical problems, meals on long flights.)

    The obsession with nickel-and-diming people isn’t just driving them away from flying. It can also be actively counterproductive – for example, charging for bags leads to long airplane loading times and delays as people stuff bags into overhead bins; there is no fuel saved in this exercise, and the book-keeping for the profits ignores things like the costs of missed connections. And complicated pricing schemes with hidden fees are less transparent, and fair, than simpler ones.

    • Marc says

      I’d also add that the current setup is extremely expensive in terms of the time of travelers – that invested in researching plane tickets, long layovers, and overloaded systems prone to cancellations and delays. There is also simply an element of unpleasant cheapness to the whole exercise; flying for regular passengers is less pleasant than taking an interstate bus used to be.

  18. Robert Waldmann says

    I think you are assuming that business fliers are personally paying the fair. My guess is that, as the name suggests, managers are stealing from shareholders (not big bosses but rather middle managers whose whines bigger bosses here unlike those of shareholders who are far away, diversified and not interested).

    Another way of putting it is that you are assuming perfect competition and competition is never perfect. The conclusion that the optimal price is proportional to marginal cost can be obtained in two ways either from perfect competition (so the ratio is 1) or assuming the elasticity of demand is the same for every good. Either assumption is always absurd.

    Here I think the point is that the huge change from legally prevented competition (pre Carter) to the current system can cause the naive to identify the current market to the ideal perfectly competitive market. The question must be if an airline raised its ticket prices by one cent (from whatever complex function of whatever they are) would it ever sell another seat. If the answer is quite probably at least one, then you mean that, again quite probably, assuming perfect competition is a mistake.

    Now explain to me why you assume that the elasticity of demand for business class seats is the same as the elasticity of demand for coach class seats. If you didn’t answer “never one more seat ever” than this is your assumption. The absolutely key necessary assumption on which you base the entire post is unstated and completely unsupported by any effort to hint at a bit of possible evidence.

    Oh and by the way, this comment is a non technical summary of a lecture I gave last year in economics 101 (by another name).

  19. Robert Waldmann says

    Sorry about the tone of the comment above. By the way, I happen to think you are a genius. But I don’t think this post is up to your usual level.

  20. says

    I think there is no difference about a seat in the economy class and the first class. It's dealing with comfort and safety. Each of it has different function and it indicates a seat is not the first priority.