Consumer Protection in the Airline Industry—Posner

Last week the Department of Transportation announced a set of regulations that it calls “Enhancing Airline Passsenger Protections II,” the “II” referring to the fact that similar “protections” were imposed more than a year ago and are now being expanded. The new regulations are summarized in an article in the New York Times published on April 20. Accompanying the new regulations is a study by a pair of economic-consulting firms (one of them the well-known Econometrica) that purports to quantify the financial benefits of the regulations and concludes that they are modest but positive. Here is the study’s summary of the requirements imposed on airlines by the new regulation: 

“1 Expansion of tarmac delay contingency plan requirements and extension of EAPP1 Final Rule requirements to cover foreign carriers.

"2 Expanded tarmac delay reporting and application to foreign carriers.

"3 Establishment of minimum standards for customer service plans (CSPs) and extension of EAPP1 Final Rule requirements to cover foreign carriers.

"4 Extension of requirements to post contracts of carriage, tarmac delay contingency plans and CSPs on websites to foreign carriers.

"5 Extension of EAPP1 Final Rule requirements for carriers to respond to consumer complaints to cover foreign carriers.

"6 Changes in denied boarding compensation (DBC) policy.

"7 Full-fare advertising and prohibition on opt-out provisions.

"8 Expanded requirements for disclosure of baggage and other optional fees.

"9 Prohibition on post-purchase price increases.

"10 Prompt passenger notification of flight status changes

"11 Limitations on venue provisions in contracts of carriage." 

Do these regulations make economic sense? (They probably make political sense.) 

I won’t try to discuss all of them, but will sample each of the three kinds of requirement that the new regulations impose: (1) requirements that alter the contract between the passenger and the airline, ostensibly to make it more favorable to the passenger; (2) requirements concerning fuller disclosure of the terms of the contract; and (related to both other categories) (3) requirements designed to prevent exploitation of consumers by trickery. 

(1) includes requiring refunds for lost luggage and increasing the compensation required for passengers who are bumped from a flight because of overbooking; (2) includes such things as requiring that taxes be disclosed as part of the purchase price rather than separately and that baggage fees be more clearly disclosed to passengers in advance; (3) includes such things as post-purchase-price increases and limiting where a passenger can sue an airline (“venue”). 

(1) doesn’t make any economic sense. If airlines have to make refunds for lost baggage or increase overbooking compensation, they will have to raise prices to cover the higher costs resulting from these requirements. If passengers preferred to pay the higher price necessary to obtain these benefits, one would expect the airlines to revise their contracts with passengers accordingly. The same thing is true with regard to limiting the amount of time that an airline can keep a plane on the airport tarmac, awaiting clearance to take off, without giving the passengers a chance to leave the plane. The new regulations, in merely extending the limitations it has already imposed on domestic airlines to foreign ones, can be thought just to be closing a loophole; the economic question is why the matter of tarmac delay can’t be left to implicit negotiation between airlines and passengers, resulting in an optimal combination of ticket price, inconvenience from being stuck in a plane, and likelihood of cancellation of flights if the combination is weighted in favor of compensation for passengers inconvenienced by tarmac delay. 

(2) is another questionable category of regulations. Competitive firms don’t disclose negative features of their product (which can include price) unless there is a competitive advantage to doing so. Assuming airline taxes don’t differentiate among airlines, disclosing the taxes as part of the ticket price rather than in fine print unlikely to be noticed is not going to give any airline a competitive advantage, and it may reduce demand slightly by revealing air travel to be somewhat more expensive relative to substitutes than passengers may have thought. The effect is likely to be trivial, however. As for baggage fees, if an airline decides to compete by charging lower fees than its competitors, presumably it will advertise the fact; it will not need government prodding. 

(3) is really a variant of (2). Take the venue limitations. Venue (where the airline can be sued) is a term in the contract between the airline and the passengers, which the Department of Transportation is forcing the airlines to delete. But many consumes are unaware of the meaning or significance of such a provision, and requiring disclosure of it would merely burden the passenger with information that he doesn’t want or need—for how likely is he to want to sue the airline? So I don’t regard these provisions of the regulations as particularly objectionable on economic grounds. 

The issues become slightly more difficult when one takes account of the airline industry’s somewhat unusual cost structure. It can be argued that the airline industry would not really be very price competitive if left to itself because the provision of airline sservice has a high ratio of fixed to variable costs. Such a ratio makes price cutting a perilous method of trying to increase profits, since if prices spiral down to marginal cost the airlines are not able to cover their fixed costs. And price changes are necessarily published in advance and airlines cannot feasibly “steal” passengers from each other with secret discounts. So tacit collusion on price should be feasible, and one might expect therefore that the airlines would do anything to pack their planes, since the cost of adding a passenger in a plan that has empty seats is very slight—anything but offer a lower price than a competitor for a given quality of service. 

But if tacit collusion on price, coupled with the cost structure of the industry, caused the airlines to substitute nonprice for price competition, one would expect the quality of service to be too high (that is, that consumers would prefer a lower price at the cost of lower quality), as in the days when regulation by the Civil Aeronautics Board largely prevented price competition, resulting in extravagant nonprice competition in the form of ultra-frequent flights and lavish in-flights meals and even entertainment. The quality of airline service has of course been steadily deteriorating. Moreover, entry either of new airlines, or of existing airlines into routes they haven’t previously served, is easy, and must keep prices down. And the ratio of fixed to variable costs in the provision of airline service has declined because of rising fuel costs, a variable cost that now accounts for 40 percent of an airline’s total costs. 

Moreover, if airlines don’t want to compete on price, requiring fuller disclosure won’t have much, if any, effect. 

But the cost structure not of the industry but of the individual airliner—the high ratio of fixed to variable costs in the operation of a particular airliner—is relevant to the possibility of “market failures” that might, in principle anyway (always a vital qualification), justify regulation. I said that the airlines are desperate to pack their planes, because an additional passenger adds much more to revenue than to cost. But packing planes, necessarily with passengers have a variety of preferences, limits product differentiation. There is some: think of first class, and the recent movement toward varying the leg room of coach seats. But it isn’t feasible for airlines to offer passengers different waiting times on the tarmac when bad weather delays flight clearance; they’re all in the same boat. And when stiff baggage fees result in delays in boarding and deboarding, and difficulty in finding bin space for one’s carry-on luggage, because the fees have caused many passengers to substitute carry-on for checked baggage, all passengers (in coach) are in the same boat. The quality-sensitive passengers may incur a great deal of disutility from the degradation of quality that enables the airlines to attract a lot of quality-insensitive (in other words, price-sensitive) passengers, yet the former may not be willing to pay the very high price necessary to compensate the airlines for losing price-sensitive passengers deterred by the high price. 

This is not a genuine market failure, however— technological constraints, rather than collusion or externalities, prevent the industry from providing a level of service desired by many passengers—but it helps to explain the public pressure for quality-enhancing regulations. The Department of Transportation thinks or pretends to think that these regulations increase overall satisfaction with airline service, but this fails to consider that if passengers as a whole wanted better service at a higher price, the industry would provide it voluntarily. Service can’t be decoupled from price. 

The airline is providing a bundled or “one size fits all” product to most of its customers, and unbundling can increase demand by enabling a better matching of price to consumer preference. But except for the tiny sliver of flyers who can afford private planes, the cost structure of the airline industry, rooted in airliner design, prevents significant quality differentiation. 

I conclude that while regulations that forbid certain deceptive practices in the marketing of airline services may be justifiable, regulations that require more detailed disclosures, and in particular regulations that require quality improvements, are not justified, at least on economic grounds. The consulting report is wrong to think they’ll increase aggregate welfare, although they will modestly increase the welfare of the complainers—illustrating that the squeaky wheel is indeed greased first.

Comments

[N]

I'll take issue with point #1, without going into points 2 and 3. Changing the contract between consumers and airlines may increase prices. I don't know what the airline industry's HHI index is, but I would imagine that the airlines are in some kind of oligopoly where they coordinate prices. Increasing variable costs would probably affect profits, but I don't see the connection with ticket prices. In addition, increasing prices may significantly reduce the number of tickets sold if int'l air travel is an elastic good.

Tarmac delays result in increased costs because of the fuel the airline must burn (in addition to consumer dissatisfaction). I don't think pilots or airlines get anything from tarmac delays. The regulation may foster a greater level of cooperation between airlines, air traffic controllers, and the FAA, by making the reduction of tarmac delays a greater priority. Pilots and ATC's would be encouraged to plan ahead by forecasting weather conditions as well as delays at airport taxi ways (where planes wait to take off) and runways.

[Jack]

One glitch in the system is that if a plane pushes back from the gate on time......... it's an "on time departure".

Obviously, if they knew there was a line-up waiting for weather or the line itself, we'd all benefit, fuel, crew and passengers, from not pushing back and waiting on the tarmac.

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