Center for Business and Public Policy
at the University of Illinois, Urbana-Champaign

As I tell my students, “I believe in markets, but I also believe in market failures.”  When the basic assumptions of perfect competition hold, markets do a great job at allocating resources efficiently.  The right goods are produced, and they find their way from the firms that produce them at the lowest cost to the consumers who place the highest value on them.  A well functioning market is a thing of beauty.

However, when the basic competitive assumptions do not hold, markets can work very poorly.  Without getting too long winded, it is reasonable to argue that industries such as health insurance and banking do not satisfy the competitive assumptions, and this provides a justification for government intervention.  For example, in health care the problems of adverse selection (the people who most strongly desire health insurance are the ones most likely to buy it) and moral hazard (when people don’t pay out-of-pocket for a service, they tend to use too much of it) are significant and serious reasons why unregulated markets may not be efficient, and introducing regulations to address these problems is the (economically) strongest argument in favor of reform.

Of course, the second part of what I tell my students is that “I believe in governments, but I also believe in government failure.”  Markets are complicated and difficult to actively manage in even the best circumstances.  Throw in the fact that governments themselves are filled with political and bureaucratic concerns that may prevent ideal regulations from being enacted, and it is easy to see why the cure is often worse than the disease.

Which brings me to my main point: government intervention should be motivated by the need to address a serious problem with markets and mindful of the fact that government has the potential to make things worse as well as better.

So, what could a group of six Democratic Senators possibly be thinking in introducing legislation aimed at preventing airlines from charging for carry-on baggage?  Where is the market failure here?  What is the great inefficiency that this legislation is supposed to address?

As Senator Schumer (D – NY) said “When you charge for a carry-on bag, it’s a slap for anyone who flies.”  Maybe.  But, people who choose low-cost airlines are saying that they prefer to be slapped rather than pay a few bucks more for a ticket.  If they don’t want to fly Spirit (the pioneer in charging for carry-ons), they can choose another airline, or another means of travel.  If people are wiling to choose Spirit despite the inconvenience of leaving their carry-on bag at home or paying to check it, then Spirit has actually done a good thing.  People just want low ticket prices.  Period.  And, Spirit is giving it to them.  That is a triumph of markets, not a failure.  Southwest in the U.S. and Ryanair in the UK/Europe have been very successful following a no-frills/low-price strategy.  The only thing preventing Spirit’s new pricing will do is prevent them from giving people what they really want: the lowest-cost seat on a plane.

On the other hand, if people choose alternate carriers, Spirit will quickly come to see the errors of its ways and remove the bag charges.  Or, if there really are benefits to the airline due to “lower[ing] some passengers’ costs, speed[ing] up boarding and lines at security checkpoints and reduce[ing] delays,” then Spirit could lower its prices even further in order to make up for the additional cost of paying for a carry-on.  Again, markets at work.

In my mind, to the extent that there is a problem here, it is that people do not know about and/or correctly anticipate the charges for things like checked bags, carry-on bags, etc.  So, if Senator Schumer and his colleagues want to do something to help here, they could think about regulation aimed at transparency in pricing.  For example, when you go to buy a ticket you could be told that “this airline charges $X for a checked bag, $Y for a carry-on, $Z for food, etc.”  This way, we could be confident that everybody was given the chance to learn about the airline’s pricing scheme.  As long as everybody knows that by choosing Spirit they save $17 on their ticket but will have to pay $45 if they choose to put a bag in the overhead bin, then we should trust market forces to bring about the right trade-off between the price of a seat for yourself and the price of a spot for your bag.

Airline travel used to be so expensive that is was considered a rare luxury. Now we fly all the time, and it seems to be cheap. Is it? Has the price really fallen so much for the same quality-adjusted product over time?

Mention airlines to a group of people, and the usual response is a collective groan, rolling of eyes or a chorus of “Do I ever have a horror story for you…” (At least in regard to North American airlines – I have heard people wax poetic about various East Asian carriers, mostly in comparison). So why is travelling such a pain these days, to the point where we consider an extraordinarily good flying experience to be one where we actually were able to get where we wanted, on time, with our luggage? One would think this should be a bare minimum – isn’t this the basic good that we’re buying?

After having 3 flights cancelled on me recently, only one of which was for weather reasons (I won’t even get into the seemingly arbitrary and often mysterious definition of what compromises a ‘weather delay’. ), I’m beginning to think that we’re actually purchasing something that was equivalent to the old standby tickets. Years ago, you could buy a guaranteed seat, or for cheaper you could buy a stand-by seat. It gave you the right to use an open seat on a flight, and if one couldn’t get on that plane, one tried with the next one. Usually you could be pretty sure to get where you were going within half a day of your first attempt. These tickets made sense when airlines were flying at 50% capacity, and before they adopted the ‘hub and spoke’ system, so there were actually direct flights from A to B. The whole standby thing got a lot iffier as soon as you were trying to link up 3 or more segments. This approach makes sense as a form of price discrimination, which you might expect in an industry with substantial fixed costs and relatively low marginal cost of letting one more person onto the airplane.

But compare that scenario to Thursday where my “guaranteed” flight was cancelled, and I, along with 100 of my new closets friends were on the standby list for the next three flights (I was number 72 – yeah for me!). These are over 100 people who have paid for a ticket on some other flight, and either had that flight cancelled, or missed it because of a late connection (in this case, they were not allowing people to go standby who were already booked on a later flight). Next to me in the crowd was a super platinum member who was not even allowed to get his name on the list, since the airline decided to cap it at about 105. This scene was repeated for the next flight which had already been oversold. In short, most of us ended up spending $100 for a hotel and cab, or spending even more for a one-way rental car, and arriving at least 12 hrs after scheduled. I admit I was particularly peeved since, on the same trip, on my way out, I had also had a cancelled flight, resulting in an 8 hr delay. Add in an overpriced airport meal and just for the one-way trip back, the real price of the plane ticket was at least $150 more than the initial purchase price, even without counting a value of time. Now multiply that by 100 stranded passengers for this one incident, and that’s a lot of economic surplus lost.

You might well be thinking that you have several stories that are far worse than mine – and I’m sure you’re right. My point isn’t only to whine (which, I admit, I’m finding cathartic ) but to think out loud about the appropriate price comparison, particularly pre and post deregulation. Many other people have noted that the old tickets used to be refundable and changeable, and argue that the appropriate comparison is full-priced tickets, which have actually gone up in price. (Consumer Reports quoted by Unbossed 2008). This argument does not even touch the added fees for things like baggage (Consumer Reports 2008)

I haven’t done research on deregulation of the airline industry, and there are a number of papers that argue its success (see Smith and Cox for an overview). My only point is that I would be interested to see a deregulation study that quality-weights the services provided. Mostly I just want to not get stuck in seat 34 E next time…