April 24, 2011
How Can Governments Help Consumers
How Can Governments Help Consumers- Becker
The new rulings announced by the Department of Transportation to force airlines, among other things, to return the fees for checking baggage if the baggage is lost, to post full prices including taxes, and to raise the compensation for being bumped involuntarily from flights, are not very onerous to airlines. However, they do add to the many rules that already require airlines to post various prices, to compensate passengers for bumping, and to engage in other behavior that is supposed to protect passengers. The new and old rules regarding passengers, and many rules of behavior imposed on companies in other industries, such as the so-called consumer protection components of the Dodd-Frank law on financial regulation, all reflect a fall in government confidence in the ability of consumers to make reasonable choices.
I believe this lack of confidence greatly underestimates the capacity of the great majority of consumers to make forward-looking choices in their own interests. It also underestimates the degree to which the forces of competition protect consumers against the consequences of the bad decisions they do make. I briefly defend each of these claims.
Low cost airlines that provide cheap tickets and minimal services grew rapidly after the deregulation of airlines that began in the 1970s allowed the entry of new airlines. Their growth shows how sensitive passengers are to price, and how many are willing to exchange lower prices for fewer services, such as no meals, or no assigned seats. Southwest Airlines started only in the 1970s after facing much opposition from regulators, and it is now the largest American airlines in terms of domestic traffic.
Or consider whether most passengers know that many airlines now add separate charges for checked baggage, even though these charges are often not displayed prominently in advertising or in passenger contracts with airlines. It is obvious from the fact that many more bags are being carried onto planes since these changes went into effect (and thereby delaying the departures of planes) that many passengers both know about these new checked bags fees, and they have responded to them. For those who may be ignorant of these fees, Southwest Airlines constantly reminds consumers in their advertising ("bags fly free") that they are one of the few airlines that do not charge for the first or second checked bags.
This is not to deny that some passengers are ignorant of the separate charges for baggage and food, do not realize that sizable taxes add to the full cost of airline tickets, forgot about frustrations due to long and unpleasant flight delays, and are unaware of other aspects of the full monetary and psychic cost of flying. However, if significant majorities of passengers are reasonably well informed about full prices of tickets and other aspects of the flying experience, their behavior helps protect the ignorant passengers. For airlines usually have to make their pricing and other decisions on what the clear majority of passengers know and respond to since they usually cannot separate the more active customers from the passive ones. If that majority is responsive to charges that are not prominently displayed, to taxes, and other aspects of the total cost and experience of flying, airlines will tend to keep prices and charges lower to all, including the more ignorant flyers.
Competition among airlines may be an even greater protection for uninformed consumers than the behavior of reasonably well-informed and responsive consumers. As Posner indicates, if government regulations impose costs on airlines, ticket prices will tend to rise since airlines have been struggling for decades just to earn a decent return on their capital.
Suppose, to illustrate the effects of competition, that one airline discovers its profits increase when some of the costs to passengers are placed in small print on the passenger ticket contract because enough passengers act as if they are not aware of the costs found in small print. Then other airlines competing for passengers will copy the first airline, and also put these costs in small print. Furthermore, their desire to get more of the now more profitable passenger business will induce them to reduce prices on other dimensions of travel, or add to services, such as providing assigned seats when seats were not previously assigned, or adding individual videos for each seat. The end result will be that competitive pressures that lower prices or increase services to passengers will help compensate passengers who do not recognize the costs in small print, although to be sure they may be only partially compensated.
So I clearly agree with Posner that the new regulations imposed on airlines are mainly a mistake. They add to the costs of airlines and to the costs of flying in the mistaken belief that most consumers are easily tricked by airlines. Beyond that, the regulators fail to see that competition is the most effective way to protect even ignorant consumers from the consequences of their ignorance. The competitiveness of the airline industry is evident from the many new airlines that have entered and existed this industry during the past 30 years, and from the low profits during the decades after deregulation. Encouraging competition in this and other industries is the only really effective way to help the great majority of consumers, including ignorant and easily fooled consumers.
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.