Three Essays on the Introduction and Impact of Baggage Fees in the U.S. Airline Industry

This dissertation encompasses three papers. My first paper examines how one firm’s decision to unbundle its product affects its competitors’ pricing strategies. Existing literature discusses the effect on prices of the unbundling firm, but previous work often ignores the asymmetric scenario where one firm unbundles while the competing firm does not. I contribute to the literature by modeling and empirically testing the asymmetric case of product unbundling on competitors’ prices using a large dataset of U.S. domestic airfares. My differentiated product model with add-on pricing predicts a firm’s base good price, regardless of whether it unbundles its own product, will be affected by competition unbundling. The predicted effect of competition unbundling could be positive or negative depending on characteristics of the firms and market. The variation in timing and implementation of bag fees among airlines during 2007-2009 provides a unique opportunity to identify the effects of product unbundling. I find competitor bag fees lead to lower ticket prices for a majority of airlines and routes. While the average effect is a 2% drop in ticket price, additional evidence indicates the reduction in ticket price is larger on longer routes, flights with a connection, and routes characterized as having a greater proportion of business travelers. These findings not only reveal a more extensive impact of bag fees than previously thought, but also lend confirmation of the theory which emphasizes the importance of a competitive effect of product unbundling. My second and third papers explore the possible forces that led to the introduction of bag fees in the U.S. airline industry. My second paper investigates whether the widespread introduction of bag fees in the U.S. airline industry is consistent with the price discrimination story of add-on fees. Existing theories on add-on pricing show price discrimination through an add-on fee increases profits only when there is enough heterogeneity in consumers’ willingness to pay for the add-on. For bag fees to be consistent with this theory, I hypothesize flight networks for bag fee charging airlines saw an increase in the heterogeneity of consumers’ willingness to pay for bag-checking services prior ii to the introduction of bag fees. I test this hypothesis by analyzing the mix of routes and passengers for each airline using ticket level data published by the Department of Transportation. In particular, I approximate the number of business and leisure travelers flying on each airline over time to identify the mix of these consumer types flying on each airline. The greater the mix of these consumer types an airline faces, the more variation in consumers’ willingness to pay to check a bag. Although I do observe changes in the overall composition of consumers for some airlines, I do not find conclusive evidence of a change in demand in support of the theory. Furthermore, the inconclusive results do not allow a rejection of the hypothesis, but instead, are likely a product of insufficient data. My final paper investigates whether changes in costs led to the introduction of bag fees in the U.S. airline industry. Along with the price discrimination story of add-on fees, economic theory also suggests that the cost of producing the add-on is an important component of the firm’s decision to charge an add-on fee. Bundling the add-on with the base good is profitable only when the costs of producing the add-on are low relative to consumers’ willingness to pay for the add-on. As costs rise, the potential profits of unbundling the add-on begin to outweigh those of selling only the bundled product. Therefore, I hypothesize that the marginal costs of transporting passengers’ checked baggage increased prior to 2007 and the introduction of bag fees. Using data from the Bureau of Transportation Statistics, along with insight from various other sources and industry reports, I evaluate changes for several costs associated with bag-checking services. I find evidence of increases in the following costs relevant to bag-checking services: fuel costs, costs associated with mishandled baggage, and the opportunity costs of cargo space on passenger service flights. These trends are consistent with the story of increasing marginal costs as a driving force for the introduction of bag fees.