This summer has seen a significant degradation in the quality of airline transportation in the United States compared with the recent past--substantial increases in delayed and canceled flights, in missed connections, in waiting time to the next flight to one's destination if one's original flight is canceled, in crowding in planes, in poor in-flight service, and in lost luggage. The delays have actually been masked by the airlines' practice of increasing scheduled times--for example, flights from Chicago to Washington, D.C. used to be scheduled to take an hour and a half, but now are scheduled to take almost two hours, yet still are late more often than when the schedule called for a faster trip.
Much finger-pointing has accompanied the degradation in service, and there is a movement afoot, well discussed in an article in the August 8 Wall Street Journal, for legislative intervention.
My guess (and that's all it is) is that the principal culprit is the difference between marginal and inframarginal consumers of a product or service that has heavy fixed costs (lumpiness). Let me explain what is actually a simple point. Competition compresses price to the intersection between demand and supply; think of the standard, simple demand-supply graph in which a falling demand curve intersects a rising supply curve. To the left of the intersection, the demand curve is above the price,. The space between the price and the demand curve denotes the existence of inframarginal customers (or quantities, but I'll disregard that detail), which is to say customers who would continue to buy the product or service even if its price were higher. They would do that because they value it more than the marginal purchaser does--the purchaser who would not buy the product if the price were any higher than competition has constrained it to be, because the marginal purchaser purchases at a price just equal to his demand, that is, to the value he attaches to having the product.
The difference between what the inframarginal purchasers pay (the market price, the same price paid by the marginal purchaser) and what they would pay (the schedule of prices traced by the demand curve above its intersection with the price) is referred to as "consumer surplus". In effect, it is value given away by the sellers to the purchasers. The sellers derive no profit from it. The only way they can increase their profits is to reduce their price, as that will attract more marginal customers; specifically, they will be customers for whom the value of the product is less than its current price but for whom the value of the product would exceed price if the price fell.
When price is at its competitive level, the sellers (unless they collude, and barring government intervention) can reduce price further only by increasing the quality of their product or reducing its cost. Reducing cost may require reducing quality, which will reduce consumer surplus. But the sellers' object is not to maximize consumer surplus, because they do not profit from it. So if reducing price by reducing cost (and therefore quality) attracts new customers because they are not as concerned with quality as the inframarginal customers are, the sellers may be better off even though their customers as a whole may be worse off.
What makes this a particularly attractive strategy for airlines to follow is that a large proportion of their costs are fixed, that is, are invariant to quantity of output. If a plane can carry 100 passengers, the cost savings from carrying a smaller number is trivial, unlike the cost savings to a retailer from selling fewer toothbrushes. (The analogy to the airplane is to intellectual property--a book, say. The fixed costs of the book will be very high relative to the cost of printing and distributing an additional copy, i.e., its marginal cost.) Even a very low price to passengers, if it fills the plane, may be profitable, because almost all the revenue goes to pay the heavy fixed costs of the plane, as in the case of the book but not the toothbrush. To the extent that an airline can price discriminate, it will, offering better service to the customers that are willing to pay for it. Hence first class and business class versus coach. (The analogy in intellectual property is to hardback versus paperback books, or to first-run versus subsequent-run movies.) However, there are limitations. If flights are canceled or delayed, all the passengers are harmed; if first-class seats are filled (for they are especially profitable to the airlines), it will be harder for first-class passengers to find a first-class seat on the next flight if their original flight is canceled; and so forth.
The inframarginal customers (I am one of them) are furious. Some of them are substituting other modes of transportation, such as car or train, for short flights, but that substitution is limited by the fact that fuel costs per mile, an increasingly high cost of driving, are actually lower for planes than for cars. At the top end of the income distribution, some airline customers are buying shares in private planes. In the middle, many are complaining to their Congressmen. In a curious way, this last response could be thought an effort to obtain legislative rectification of a market failure. For it is possible, if my analysis is correct, that aggregate economic welfare, in the form of the total combined consumer and producer surplus of airline transportation, has declined as a result of the airlines' competition for the marginal customer. However, it is extremely unlikely that such a market failure could be rectified by legislation at a cost equal to or greater than the benefits.
It might be asked why the quality of airline service has been falling recently, rather than having always been low (at least since deregulation, which by limiting entry and price competition encouraged airlines to compete by providing better service). The answer is that the costs of air transportation have been rising recently as a result of sharply higher fuel costs. So it is not that the airlines are actually reducing fares, as I assumed for purposes of simplifying my analysis--in fact they are raising them. But they are not raising them to the level necessary to maintain the previous quality of service, because if they did that they would lose their marginal customers.
Most markets adapt to differences in consumer preference by offering different qualities of product at different prices. But except at the very high end, where as I said some airline customers are switching to private planes and private charter services, this is not happening in the airline industry. The impediments include the network character of the industry, the fixed costs of airplane transportation, and the spillover effects of airline delay--the inability of airlines to adhere to their schedules complicates air traffic control.
Speaking of which, the airlines argue that the air traffic control system is antiquated and that this is contributing to air-traffic delay. I find this implausible, because the the system, though operated by the government, is 90 percent financed by taxes on aviation fuel. If the airlines want a better system, they should support rather than oppose higher taxes.