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Airline Baggage Fee and Game Theory

When people think of logistic networks, the route maps stowed in airline seat-back pockets may come to mind. The airline industry forms a huge logistic network. Billions of passengers rely on the network to connect around the globe. In a previous blog post (see link below), I have digged into how the airlines’ route structures (spoke-hub paradigm vs. point-to-point paradigm) evolve. This post will attempt to investigate another phenomenon in the industry: the airlines’ baggage policy change.

Until ten years ago, checking baggage free was something passengers would take for granted. However, after American Airlines became the first major airline to charge baggage fee in the United States in 2008, all the other major airlines (except JetBlue and Southwest, which still have free-checked bags now) followed the strategy within three years. It is intriguing to notice how the airline industry could entirely overthrow a service that had been considered as a norm for decades within such a short period. The same phenomenon also applies to onboard meal service since a few airlines dropped it after the 9/11 attacks.

We can attempt to explain the airlines’ strategies from the perspective of game theories. According to the “Baggage Fees A Game Theory Perspective” paper, there are two key games involved: airline vs. passengers, and airline vs. competitors.

We first look into the game between an airline and its passengers.  For the airline, we assume it has two options: to charge a certain amount of baggage fee or keep checked-baggage free. On the other hand, we assume the passengers can choose whether or not to switch to another airline following the airline’s decision. For the sake of simplicity, we also assume a passenger is booking a flight ticket on a price-comparison website (e.g. Kayak, Expedia) and the airline is selling the ticket at the lowest $200, while the second lowest price is offered by its competitor at $201. The proposed baggage fee is $15.

With these assumptions, the problem can be formulated to a game tree model.

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From the diagram, it can be seen that if the customer switches airline, the company would lose $200 revenue and the customer would also lose a dollar for paying a higher price. If the customer chooses to stick to the airline, he would have to pay extra fee once the airline decides to charge it. Since the airline plays its strategy before the customer, we could see the airline would choose to exclude baggage fee in flight fare in order not to lose the customer because losing a customer will definitely bring it losses.

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After the customer has bought the ticket, to achieve a higher revenue, the airline would choose to charge extra baggage fee on this stage. Note that the airline has to impose a cancellation fee to prevent the customer from switching airline at this point. Obviously, the passenger would choose to pay the baggage fee to minimize his loss.

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In this way, naive customers who are not informed of baggage policy differences would be enticed by a lower flight fare and hence have to pay the baggage fee. The airlines that charge baggage fees will at least win this group of customers for a period of time. Therefore, most airlines chose to impose a baggage fee around the same time to keep up with competitors on the lowest-fare game.

However, to stay profitable, the airlines need to make strategic decisions with a much more complex model that involves several extra parameters such as customer defection and competitor withdrawal. In this game, airline vs. competitors in a long term, the paper gives an explanation as to why the airlines would cooperate rather than defect to maximize their profits. Due to its complexity, this post would not discuss this game in detail.

In conclusion, it is surprising to see how the massive industry is based on such a fragile system that requires innocence of customers and coordination of competitors. To survive the fierce competition in the industry, airlines have to make meticulous decisions based on knowledge in areas such as game theory and behavioral economics. Any innovative move led by a single company could change the whole industry and all customers.

 

References:

  1. http://blogs.cornell.edu/info2040/2014/09/29/reflection-on-airlines-spoke-hub-network-after-ohare-fire/
  2. Baggage Fees A Game Theory Perspective http://faculty.haas.berkeley.edu/rjmorgan/mba211/2010%20Final%20Projects/Garde%20Final%20V%205.0.pdf

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