Would the Social Planner Let Bags Fly Free?

Abstract

Motivated by airline baggage fees, we consider a service provider offering a main service (e.g., transporting a person) and an ancillary service (e.g., transporting a checked bag) that an individual customer may or may not need. We ask whether the firm should bundle the two services and post a single price or unbundle them and price the ancillary service separately. We consider two motivations for unbundling the services. The first focuses on altering consumer behavior to lower the firm’s costs. We assume that providing the ancillary service is costly but consumers can exert effort in order to reduce the rate at which the ancillary service is needed. We show that the firm unbundles and sets the fee for the ancillary service at the same level the social planner would. Profit maximization thus results in social efficiency. The second rationale for unbundling is segmentation. We assume that there are two segments that differ in the rate at which they use the ancillary service. The optimal contracts impose higher ancillary service fees on those less likely to use the service. In the airline setting, this would imply that business travelers would face higher baggage fees than leisure travelers. We conclude that the way in which airlines have implemented baggage fees is more consistent with attempts to control consumer behavior than segment customers.

Keywords: baggage fees, airlines, operations management, revenue management

JEL Classification: M11, M20