Product Unbundling in the Travel Industry: The Economics of Airline Bag Fees

• Date: 01 September 2015
• Published date: 01 September 2015
• DOI: http://doi.org/10.1111/jems.12106

Product Unbundling in the Travel Industry: The

Economics of Airline Bag Fees

JAN K. BRUECKNER

Department of Economics

University of California

Irvine, CA 92697 USA

jkbrueck@uci.edu

DARIN N. LEE

Compass Lexecon

200 State Street, 9th Floor Boston, MA 02109

darin.lee@compasslexecon.com

PIERRE M. PICARD

Department of Economics

University of Luxembourg

Campus Limpertsberg 162 A, avenue de la Fa¨

ıencerie L-1511 Luxembourg

pierre.picard@uni.lu

ETHAN SINGER∗

Department of Economics

University of Minnesota

1925 4th St S, Room 4-101 Minneapolis, MN 55455

singe119@umn.edu

This paper provides theory and evidence on airline bag fees, offering insights into a real-world case

of product unbundling. The theory predicts that an airline’s fares should fall when it introduces

a bag fee, but that the full-trip price (the bag fee plus the new fare) could either rise or fall. The

empirical evidence presented in the paper provides strong confirmation of the first prediction. The

data also suggest that the average fare falls by less than the bag fee itself so that the full price of a

trip rises for passengers who choose to check bags.

1. Introduction

Product bundling and unbundling by firms has been a focus of researchers in industrial

organization ever since the seminal contributions of Stigler (1963) and Adams and Yellen

(1976).1Although consumers may have only been vaguely aware of the impact of firm

∗A portion of the empirical work in this paper is based on analysis contained in an expert report by Darin Lee,

who was retained by Delta Air Lines in connection with a class action litigation filed in U.S. Federal Court.

However, the opinions expressed areentirely ours. We thank an associate editor and a number of referees for

helpful comments.

1. In addition to Adams and Yellen (1976) and Stigler (1963), see Schmalensee (1982) and Lewbel (1985)

for other early papers on bundling. The literature presents models where consumers demand either zero

or one unit of different products. Firms can offer no bundles, pure bundles or mixed bundles according to

whether they offer their products separately,jointly, or in both fashions. The literature emphasizes the result

that monopolies have incentives to bundle products to discriminate among consumers. Evans and Salinger

(2005, 2008) emphasize cost-savings from bundling as another force behind the practice. The related tie-in

C2015 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume24, Number 3, Fall 2015, 457–484

458 Journal of Economics & Management Strategy

bundling decisions on the product choices available to them, recent developments in the

airline industry have brought the bundling issue into sharp focus. In recent years, airlines

have unbundled key elements of the product they offer, introducing separate charges

for in-flight food and for checked baggage, services that were previously included in the

ticket price. In addition to being obvious to millions of fliers, this product unbundling

has received widespread coverage in the press, with the reports typically highlighting

passenger unhappiness with the new bag fees.2

The new fees, especially the charges for checked baggage, have generated a sub-

stantial amount of revenue for the airlines. Data provided by Bureau of Transportation

Statistics (2010) show that airlines collected approximately $2.5 billion in bag fees in

2009 and $3.5 billion in 2012. Although the typical observer might view this new source

of revenue as a windfall for airlines, economists would think twice before reaching such

a conclusion. The typical $20 fee charged for the first checked bag represents an increase

in the effective fare for those passengers who pay it, amounting to a 10% increase over

a typical fare of $200, measured on a one-way basis. If airlines lack the pricing power to

impose such an increase in the cost of travel, economic theory suggests that they would

have had to cut base fares in offsetting fashion when imposing “first bag” fees.3

The possibility that the adoption of bag fees may put downward pressure on base

fares seems to have entirely been overlooked in the voluminous popular discussions of

the new fees. Airlines, of course, never announced any bag-fee-related fare reductions,

but the carriers have ample opportunity to quietly reduce fares via their yield man-

agement systems by allowing more tickets in the cheapest fare classes to be sold. The

purpose of this paper is to explore this possible connection between airline fares and bag

fees, both theoretically and empirically. The paper begins by developing a theoretical

model that portrays an airline’s profit-maximizing choices of both the base fare and the

bag fee. The model predicts that bag fees lead to a decline in the base fare. Although this

fare decline can be viewed as a natural outcome, establishing the result theoretically is

not straightforward. The prediction is then tested empirically, using detailed fare data

from the U.S. Department of Transportation (DOT). The empirical results confirm the

theoretical prediction, with an airline’s average fare falling when it starts collecting a

bag fee, but by less than the amount of the fee.4Given the rarity of empirical work

on the effects of product unbundling, these empirical results are highly noteworthy. In

addition, the findings are distinguished by their focus on a visible unbundling event.

The fact that checked-bag service would only be purchased conditional on purchase

of an airline ticket (never being bought on its own) makes a model of “add-ons” the

appropriate analytical framework. Ellison (2005) developed an add-on model, using

Internet service in a hotel room or extended warranties for cars and appliances as

examples, but he assumed that the consumer only learns the price of the add-on when

purchasing the basic product. Although some airline customers may have been taken by

literature argues that a firm can leverage its profit by tying one product to another.Posner (1976) argues that

monopolies have no such incentives because they unprofitably lose the flexibility to adapt some prices under

a tie-in. However, Tirole (1988) shows that monopolies should set the prices of complementary products to

lower levels than would two independent firms. Davis and Murphy (2000) use this argument to argue that

Microsoft followed a profitable path in setting Internet Explorer’s price to zero.Whinston (1990) demonstrates

that tie-ins could deter entry in a dynamic setting where they are irreversible.

2. See, for example, “More consumers pack lighter,smarter to save when flying”, USA Today, June 1, 2010.

3. Fees for second checked bags were adopted prior to those for first checked bags. However,only a small

share of domestic passengers checks two pieces of luggage.

4. Some individual fare reductions, however,could exceed the amount of the bag fee, an outcome that is

shown to be theoretically possible.