With fuel costs plummeting, why haven’t airlines dropped ticket prices? After all, airfares rise pretty quick when has prices rise. After all, supply and demand are all that matter in a free market, right? What goes up must come down, right?
Ah, were it only that simple. Here’s another lesson for those who think “free” markets always know best. They do, except when they are broken.
Let’s review the situation. Lower gas prices have been good for (almost) everyone. The typical American family will save $750 this year, thanks to the pump relief. But that’s nothing compared to the $5 billion that American Airlines says it will save this year, thanks to lower gas prices. What’s happening to that boom?
It’s certainly not being returned to consumers in the form of lower prices. Funny, because airlines added all manner of fuel surcharges and ticket price increases when gas surged in 2009.
An economist would tell you that this state of affairs cannot last. Sure, a naturally greedy company will attempt to pocket the savings. But pretty soon, a competitor will see a chance to grab market share, break ranks, and lower prices. That would trigger a price war, effectively allowing consumers to benefit from lower airlines costs.
That’s how it’s supposed to work. Reality is quite different. A really good economist would tell you that markets often suffer from “asymmetric price adjustment,” and that higher prices are “sticky.”
People disagree as to why, but there are a number of factors at play.
Why would airlines lower prices if competitors aren’t? Thanks to mega-merger after mega-merger, many of America’s most popular routes are only served by 2 or 3 airlines now. It’s not hard for them to work together to keep prices artificially high. Doing so doesn’t require overt collusion. Game theory suggests price signaling in the market is enough for airlines to keep each other comfortable that a price war isn’t coming. If there were 10 or 20 options for fliers, that would be hard to pull off. When there’s only 2, it’s pretty easy. Also, don’t be fooled into thinking that there are dozens of airlines whose names you’ve heard, so there must be competition. Flying is subject to “local” monopolies/duopolies, and that’s what really matters. See this story about the US Air/American Airlines merger, which includes dramatic data from the Wall Street Journal, like this: After Continental and United merged, prices between Newark and San Francisco jumped 49.9 percent between 2009 and 2012. Denver to Houston trips jumped 56.9 percent. After Delta and Northwest combined in 2008, the results were similar: Atlanta to Minneapolis climbed 39.3 percent; Cincinnati to Memphis climbed 65.6 percent.
Consumer laziness and reference pricing
Behavioral economists will tell you that consumers often aren’t rational; they don’t always search for the lowest price. In fact, they tend to search much more when prices are rising than when they are falling. That helps prices remain high. Also, when prices fall a little, consumers are often content that they’ve gotten a good deal, allowing airlines to get away with returning only a tiny fraction of their savings to the marketplace. Reference pricing plays a part in that: if a ticket from New York to Florida cost $300 last year, but only $285 this year, many consumers will use that $300 as a mental anchor, and take for granted that $285 is a good deal — even if airline fuel costs are 50 percent lower.
Downward price rigidity
I find the most compelling explanation is something that’s called “downward price rigidity.” When a price shock occurs — say, fuel prices spike — airlines are in big trouble. In some cases, they can lose money on a ticket if they don’t raise prices. The crisis is immediate, so prices react quickly on the way up. On the other hand, when costs go down, the crisis is….well, what’s the crisis? Eventually, firms have to worry that someone else might lower prices and they might lose consumers…at least those who are committed to searching around, and as we’ve already seen, not everyone is. But that problem develops much more slowly than the “if-we-sell-this-at-this-price-we-lose-money” crisis. So, prices rise higher than they fall.
A couple of years ago, when gas pump prices lagged behind sinking oil prices, I wrote a lengthy explanation of this phenomenon on The Red Tape Chronicles. I’ve archived it here. In short, I explained the research of economist Sam Peltzman — a free market advocate not known for consumer-friendly research. He conducted a vast study of price “shocks,” which could have dispelled complaints about slow-falling prices as yet another whiny consumer myth. Instead, it fueled the fire. His review of 77 consumer goods that had been subject to abrupt price increases – including gas — led Peltzman to write a paper called simply “Prices rise faster than they fall.”
“The title summarizes the main result: the person in the street is right and we are wrong,” Peltzman wrote.(PDF) In fact, the results were so vexing he called it “a serious gap in a fundamental area of economic theory.”
For now, I worry less about the gap in theory and more about consumers getting screwed. Is this normal price rigidity, or a function of a airline industry that’s severely lacking in competition. We will know soon. And if so, there’s a much thornier question to ask: how do we fix this broken market? It’s going to be hard to undo all those mergers than left four airlines in charge off 80 percent of air travel.
What does all this mean for you, dear traveler? More than ever, it’s important for you to shop around when booking travel. There really may be a better prices out there.