Microeconomics Comprehensive Exam

QUESTIONS
2. Some airlines are charging separate fees for various aspects of their services, such as checking luggage and meal service.
a) What advantages exist for the airlines of doing so?  (What are the impacts on their producer surplus, profits and competitiveness?)
b) What are the impacts of such service-differentiated pricing on consumers?  (Distinguish two different consumer groups – one that does not demand the service for which the separate fee is leveraged and one that does.  How will demand and consumer surplus of each group be affected?)

In response to a separate fee on checked luggage, many travelers decide to increase the amount of luggage they carry on an airplane.
c) How can and should the negative externalities of excessive carry-on luggage be internalized?
d) What are the welfare implications of such internalization of externalities?

MY ANSWER

Microeconomics Comprehensive Exam
Fall 2010

Question2


2. Some airlines are charging for separate fees for various aspects of their services, such as checking luggage and meal service.
a) What advantages exist for the airlines doing so? (What are the impacts on their producer surplus, profits, and competitiveness?)
Assumptions
**For this question, I’m assuming that people do not need to check luggage or need to be provided with meal service. When they buy a plane ticket, the good they are buying is simply transportation. This is a reasonable assumption, because it is unlikely that most people would choose not to travel only because they will not be served a meal, or because they have to pack more efficiently. In this case, presenting these additional services as choices to people acts simply as a way for consumers to signal to airlines their willingness to pay.
**I’m also assuming that the airlines have a fixed cost per person for flying, which is not meaningfully affected by whether by whether or not a person has luggage or eats a meal.  (The alternative would be to say that the cost of passenger to the airline changes, so that a person with no luggage, or who does not consume a meal, would induce a lower cost to the airline.)
**I’m assuming that the airline market is in monopolistic competition. Airlines are price-makers, buyers are price takers, the airlines do not behave strategically, and entry into the market is free.

Price discrimination: One reason airlines may want to charge separate fees for various aspects of airline services is to engage in price discrimination (charging different consumers different prices for the same good). Firms engage in price discrimination because people typically differ in their willingness to pay, and the firm would like to charge a high price to the people willing to pay the higher price, but they don’t want to lose customers not willing to pay that high price.

A charge on checked luggage or meal service is a type of second-degree price discrimination. This is where a price schedule is offered to all buyers and they sort themselves through self-selection. In this case the action taken by the consumer (to purchase these additional airline services or not) serves as a signal of the underlying characteristic on which the firm really would like to base its price.

Price discrimination is possible because airlines are price-makers in the monopolistic competition market, and because the consumers cannot engage in arbitrage. Also, the firms can identify consumers with different demands for its product through screening.

Competitiveness: The effect on competitiveness of the airline that starts charging fees depends on three things. First, it may depend on what other airlines do (whether they charge the same fees, or not). If they do all charge the same fees, then airlines maintain the same relative competitiveness as before the fees.

Second, the effect on competitiveness will depend on the degree to which airline flights are heterogeneous and can be differentiated by consumers.  This aligns with the assumption of monopolistic competition made above. If airline flights are heterogeneous, then people will not choose to change airlines just because of the price change, and the airline can remain competitive. For this question, I’m assuming that airlines are heterogeneous and that all airlines are using the same fee structure. [This is a model of a market in monopolistic competition, where all airlines happen to have chosen to use fees.]

[If (before price discrimination occurs) the airline market was in pure competition, and airline transportation was homogeneous (it’s just as good to take Delta from DC-Boston as it is to take United), then the airline that imposes the additional fees will lose consumers to other airlines (its competitiveness will decrease, it will lose customers, and its producer surplus and profit would fall).]

(In reality, transportation is somewhat heterogeneous, since people have particular airlines that they prefer and are willing to pay more to fly on, so while some customers may be lost due to service fees, not all of them are. Also, it seems that airlines have been coordinated in their choice to impose additional fees, so each airline has remained competitive.)

Third, the effect on competitiveness will depend on whether there are close substitutes for air travel. If there were, then if airlines create fees, people may switch to a substitute – train or car travel, for example. However, if there are not close substitutes, then the airline fees will not cause people to switch to a substitute. (In reality, for most flights, airplane travel is much faster than traveling by car and train, so there are not close substitutes.) For this question, I’ll assume that there are no close substitutes for air travel.

Producer Surplus and Profit: In the case of airline fees, taking into account my two assumptions above, then second-degree price discrimination raises the seller’s profit and producer surplus.

Simplified Example: A simplified example can help illustrate this point. Say that the airline originally sold tickets from DC to Boston for $100, with all services included. There 10 customers (type 1) who are willing to pay $150 for the flight, but they want to be served a meal, if they are not going to be served a meal, then they’re willing to pay only $40. Another group of 90 customers (type 2) are willing to pay $100 for the flight, and they really don’t care whether they get a meal or not (airplane food isn’t very tasty, and the probably wouldn’t have eaten it anyway). In this case, the airline would like to charge $150 to type 1 customers, but if they charge $150 for a flight with a meal, then the type 2 customers will no longer fly, and their total revenue would be only 10*$150=$1500. If they charge $100 for a flight with a meal, then everyone will fly, and their total revenue would be 100*$100=$10,000. However, the airline could increase its profit if it could offer flights at a price of $100 to people who don’t care about meals, and $150 to people who do. Then its profit would be 10*$150+90*$100=$10,500.  This is an increase in profit of $500. The airline can achieve this outcome through screening by offering the same price schedule to everyone - $100 for a flight only, and $150 for a flight with a meal (a.k.a $50 charge for a meal). Then the individuals will self-select and reveal their willingness to pay. The type 2 people would be happy with the cheaper, $100 flight, since they didn’t want a meal anyway. The type 1 people would choose the $150 option. In this case, the increase in producer surplus is a transfer to the producer from the consumers that had a higher willingness to pay.

General: Even if we don’t make the simplifying assumption in the example, we can still assume that by using price discrimination, the producer can increase profit and producer surplus using second-degree price discrimination.

b) What are the impacts of such service-differentiated pricing on consumers? (Distinguish two different consumer groups – one that does not demand the service for which the separate fee is leveraged and one that does. How will demand and consumer surplus of each group be affected?)
(There should be no change in demand – i.e. shift of the demand curve – due to price discrimination, because the only change is in the price of the good itself. There are no changes in individuals’ income, prices of related goods, or tastes and preferences. Only quantity demanded may change.)

Simplified Example – Two types of people
Quantity Demanded: Under the assumptions made above (that all airlines adopt the same fee structure and/or that airline flights are considered heterogeneous), and that there are only two types of people (type 1 and type 2), there is no effect on the quantity of flights demanded. The only change is the increased ability of the airlines to take advantage of differences in individual’s willingness to pay.

Consumer Surplus
People who are willing to pay for meals (type 1): Under the assumptions made above, this group of consumers will lose consumer surplus – some of their consumer surplus will be transferred to the airline, now that it has identified their higher willingness to pay for flights with additional airline services.

People who are not willing to pay for meals (type 2): Under the assumptions made above, this group of consumers will still get to fly at the same price, so their consumer surplus doesn’t change. However, there could be some welfare losses because the person now has to spend more time to pack more efficiently, or has to exert extra effort to carry all their belongings on the plane, rather than checking.

General
Consumer Surplus: However, the assumption that there are only two types of people, with such simple demand curves is somewhat unrealistic.  In reality, the effects on consumers of second-degree price discrimination are difficult to determine. First, price discrimination will result in some of the consumer surplus being transferred to the producer, and in this way, consumer surplus goes down. Some consumer surplus could go up, if people that previously would have been priced out of the market are able to enter, and if they pay less than their full willingness-to-pay. However, consumer surplus could also be reduced because of the inconveniences associated with the new restrictions on flights (i.e., they have to carry on luggage, or bring food from home.)

Quantity Demanded: The effect on the quantity demanded depends on the price that would have been offered if there was no price discrimination. For example, if the original (non-discriminating) price was between the two prices offered with price discrimination, then there will be some individuals who wouldn’t have been able to afford to fly at all, who are now able to fly, due to the lower price being offered.

In response to a separate fee on checked luggage, many travelers decide to increase the amount of luggage they carry on an airplane.
c) How can and should the negative externalities of excessive carry-on luggage be internalized?
An externality is the direct effect of the actions of one person or firm on the welfare of another person or firm, in a way that is not transmitted by market prices. In the case of airlines, the externalities or bringing excessive carry-on baggage may include slower loading times for the plane and a lack of space for some people’s things in the overhead bins (so that they must put them under the seat and have less leg room).

Charge fees for carry-ons: To ensure that people recognize the social cost of bringing a large carry-on, the airline may decide to charge a fee for carry-on luggage. Ideally, this fee would be equal to the difference between the private marginal cost to the individual of bringing the carry-on luggage onboard and the social marginal cost of this action. This would be similar to a Pigouvian tax, which is leveled on each unit of the externality in an amount just equal to the marginal damage (MD) it inflicts upon society at the efficient level. In the case of carry-on luggage, this fee might be simply for the number of pieces of luggage, or it could be assessed by size or weight. (The airline would have to consider the costs of these different methods – it is likely much simpler to charge a fixed price per piece of luggage, rather than forcing everyone to weigh their carry-on and then pay a fee.)

Make a rule: The airline could also simply make a rule that no carry-on bags are allowed, a rule to restrict the number of carry-on bags per person, or a rule to restrict the size of carry-on bags to items that will fit under the seat. Some rules about carry-on size and number already exist, and these simply be adjusted. (It is important to note that while the rule may eliminate the externality, it does not actually cause the externality to be internalized by the individual.)

The more efficient method of dealing with the externalities of carry-on bags is to charge a fee for them. In this way, people are able to decide for themselves whether they are willing to pay to have their luggage with them or whether they would prefer to check the luggage or fly without it.

d) What are the welfare implications of such internalization of externalities?
The implications of charging a fee for carry-on luggage would be to increase the cost to individuals of bring carry-on bags. Individuals would choose to pay to carry-on luggage up to the point where their private marginal cost plus the fee (which represents the difference between the private marginal cost and the social marginal cost) was equal to the individual’s marginal revenue. This would probably result in most people cutting back on the amount of carry-on luggage that they bring on-board.

The fee that they pay would be a transfer from consumers to producers (the airlines).

In addition to the changes mentioned above, everyone is better off because the externality has been eliminated (due to its being internalized). Now they can board the airplane more easily and have more leg room.

Overall, by internalizing the externality and moving to the efficient level of carry-on luggage, there will be a net welfare benefit to society. (Area A on the graph below)