Red Pen Edit: Alex Tabarrok on airline cancellations

I disagree with one of my favorite economists

Photo by Benjamin Wong on Unsplash

Of all the econ blogs out there, my favorite is Marginal Revolution. Started by Tyler Cowen and Alex Tabarrok in 2003, and the two have posted daily ever since. The blog is centered around economics, but the posts run the gambit on everything from art to teetotaling. They are short, insightful, and often have a lively comments section. If you’re looking for one blog to add to your daily life I would recommend Marginal Revolution.

I also almost always agree with Cowen and Tabarrok. This isn’t a big surprise as we are all economists. Reading work by those that have a similar mindset to you is useful; the posts on Marginal Revolution often give sound reasoning to like or dislike various policies. But with any two people, there will not be complete overlap. So it was to my surprise when I disagreed with a post by Alex Tabarrok about new proposed flight cancelation rules. It’s a short post, so please read it in full at this link. The main gist is comparing new flight cancelation rules to buying a Happy Meal:

President Biden says “We’re planning to make it mandatory for airlines to compensate travelers with meals, hotels, taxis, and cash, miles, or travel vouchers when your flight is delayed or cancelled because of their mistake.”

A classic example of the Happy Meal Fallacy:

Some restaurants offer burgers without fries and a drink. These restaurants cater to low-income people who enjoy fries and drinks but can’t always afford them. To rectify this sad situation a presidential candidate proposes The Happy Meal Act. Under the Act, burgers must be sold with fries and a drink. “Burgers by themselves are not a complete, nutritious meal,” the politician argues, concluding with the uplifting campaign slogan, “Everyone deserves a Happy Meal!”

Tabarrok is discussing what economists call “bundling”. Bundling is when a company combines several different goods or services together and sells them as one product. A clear example of this is the Happy Meal. Customers purchase a drink, fries, and a sandwich all for one price. Consumers like bundling because it allows them to purchase several items all at once and at a cheaper price than purchasing each item à la carte. Companies like bundling because it allows them to increase their profits by getting consumers to buy more than they would otherwise.

Over the last few decades, airlines have moved away from bundling and toward à la carte service. Buying a plane ticket in 1990 meant a passenger not only got to travel from point A to point B but also would also get to check up to two bags and bring a carry-on. Today, customers often complain that they have to pay extra to check a bag (Southwest being a notable exception). However, as an economist will point out, the reality is different. In 1990 customers were forced to pay for a checked bag and carry-on. Checked bags are not “free” on Southwest. They are “included”. If you fly Southwest, you are paying for a checked back whether you like it or not. Customers that fly Southwest and don’t check a bag are effectively paying for others who do. Customers that fly Spirit, on the other hand, get to choose whether or not they check a bag. If they don’t, then their plane ticket is cheaper than someone who does.

Where I disagree with Tabarrok, however, is whether mandatory vouchers for canceled flights should be viewed as the same type of bundling. I suppose it could be thought of as bundling in a very broad sense, but there’s also an either/or quality about it. This isn’t the government saying that all plane tickets must include a free hotel night or a meal on the plane (which would definitely be bundling). It’s the government saying that if airlines don’t provide the service they are paid for, there are penalties.

Tabarrok is right that these penalties will increase costs for everyone. It’s easy to see that if airlines had to pay $5,000 to every customer who had a canceled flight, airfares would increase dramatically. But any penalty will increase prices. Currently, airlines have to offer customers a refund if their flight is canceled, regardless of the reason. This rule also increases airfares for all customers. But would we be better off if airlines never had to give refunds? I think not. Punishing companies for breaking contracts will always result in higher prices for customers, but that’s a necessary side-effect to a welfare increasing policy.

This get’s to Tabarrok’s final point:

To recap, requiring firms to sell benefits that customers value less than their cost makes both firms and customers worse off. And if customers value the benefits at more than the cost then that’s a profit opportunity and there is no need for a mandate.

I agree with the logic in the statement but don’t think it applies to this situation. First, there is high uncertainty regarding flight cancelation, especially from the consumer’s standpoint. This makes it difficult to accurately gauge benefits and costs. An airline that charged higher prices but guaranteed canceled flight hotel stays and meals might be unsuccessful even if they delivered a better product because customers inaccurately measure their flight cancelation risk or their flight delay disutility. For example, on more than one occasion I have booked a flight with a long layover because it was cheaper but then regretted it once I was stuck in an airport for five hours. When buying the flight I was focused on the cost and underestimated how much I would hate waiting in the terminal. I suspect this kind of thinking is commonplace.

Second, I think Tabarrok discounts the market power airlines have and how difficult new entry is. Due to the insane rules governing US airlines (some of which I covered in this post) airlines can forgo offering a beneficial service to their customers. Airlines do not operate in a free market - there are many inefficiencies that a new entrant, if they jump through all the requisite hoops, can exploit. Just look at Avelo Airlines. Avelo’s first flight was in 2021. Today, it flies to 17 destinations from New Haven, Connecticut, an airport that used to have ZERO commercial flights. Clearly, the benefits outweighed the costs of offering commercial flights from New Haven, yet the airport was chronically underserved.

Of course, like any regulation, these could go overboard. Forcing airlines to pay customers $5,000 for a cancelation would be overkill and would be a net cost to society. So what is the correct penalty? I don’t have any formal framework for this, but I think having airlines pay for meals and lodging while customers wait to be provided with a service they have already been paid for sounds like a fair trade. The passenger is still worse off; they would prefer to be at their destination. But they don’t incur additional fees waiting to be provided with the service. Airlines also will be incentivized to provide better service. This will cost more, yes, but it would make flying less unpleasant for everyone.