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Thursday, May 23rd, 2013

Unbundling of Airline Services in India – an Economic Perspective
posted by Saattvic

On April 30, India’s Ministry of Civil Aviation allowed airlines to unbundle charges for services including drinks (except drinking water), carriage of sports equipment, seat selection, baggage and so on.  While some airlines have implemented additional charges for some services and reduced their free baggage allowance, base fares have not yet declined.  The Air Passengers’ Association of India opposed the unbundling decision and worries that the decision would merely be a licence for airlines to indirectly raise fares.  Airlines contend that base fares would reduce once they acquire a clearer picture of the potential revenue generating power of ancillary services.

In our article of 3 May 2011 for the Competition Law Insight analysing the Surcharges Supercomplaint by the UK Consumer Forum Which? to the UK Competition Commission (http://www.europe-economics.com/publications/the_surcharges_supercomplaint.pdf), Dr Stefano Ficco and I analysed the practice of airlines charging extra for online booking services in the UK.  The Supercomplaint contended that the charges were unfair and anti-consumer.  Our analysis at that time is very relevant to the current situation in Indian aviation.

A package of services

In our article, we had written that the product in question was a package of services that enabled the customer to move from one city to another.  This includes the price of the ticket as well as that of any ancillary services.  There is even an argument to include transport to and from the airport within the package (as evidenced by many airline booking sites offering to book a taxi pick up and drop off with the ticket).  It is the price of the complete package that the customer takes into account while making a purchasing decision.

Unbundling and efficiency

Consumer preferences naturally vary when it comes to a bundle of airline services.  Some consumers might be flying for a short time, and would not wish to carry too much baggage.  Passengers with slight mobility issues (such as the elderly) may place a premium on being able to sit in the first two rows.  When the entire bundle is priced at a single price point, airlines are unable to take into account the different willingnesses to pay of different customers for different parts of the package.  Unbundling allows service providers to adjust to variations in consumer preferences.  Moreover, if certain ancillary services are priced in proportion to cost, this could reduce or eliminate perverse incentives facing customers.  For instance, charging for baggage could incentivise passengers to carry only as much as they require, leading to reduced weight and subsequently savings on fuel.

Since the price of the complete package is taken into account by the customer, unbundling would have the effect of allowing providers to provide several, slightly differentiated, products where earlier they could only differentiate based on limited criteria like class of travel.  The Indian aviation sector is sufficiently competitive – data from the Directorate General of Civil Aviation shows that the largest carrier has a market share of 30 per cent and four carriers have shares of over 19 per cent – and this would limit the ability of airlines to use pricing of ancillary services to extract any more surplus from customers than they are currently doing.

Theoretically, at least, unbundling should lead to an efficiency gain.  Consumers, faced with an incentive structure for every service can calibrate their package according to their preferences, and being able to charge for ancillary services should lead to a reduction in base fare as the price for the total package remains the same, or reduces due to properly incentivised consumer choices.

The death of traditional aviation in India?

Of course, the model described above has been adopted consistently for a long time by low cost carriers in Europe (like easyJet and Ryanair).  This has not led to the complete elimination of airlines offering only the package rather than its constituent parts.  Two insights from behavioural economics can easily explain this.

First, there is a known disutility associated with making too many choices – a mental transaction cost.  For some customers, the extra time and mental energy spent deciding on each of the constituent parts of the package may not be worth the monetary savings in relation to deciding on a package price.

Second, since flying with low cost carriers may be seen as a signal of belonging to a lower economic class, there might be a ‘social status’ premium that some fliers might attach to not flying with a low cost carrier.

These factors, specially the first, should guarantee that traditional all-inclusive tickets will remain a part of Indian aviation.

Potential pitfalls – search costs

There have been recent media reports to the effect that the Indian Ministry of Civil Aviation is likely to ask airlines to increase transparency regarding the services they would charge extra for and is considering capping the number of ‘privileged’ seats that may be reserved on payment of a fee.  This is closely related to an issue we raised in our article for the Competition Law Insight in May 2011 – that of search costs.  The issue, in a nutshell, is that the total package price is not known to the consumer a priori.  The customer has to search for the prices of ancillary services, which are often revealed only at the end of a lengthy booking procedure in order to learn the final price.  The time and energy invested in learning the price entails a cost.  I quote from our 2011 article:

“In economics, search costs are known to detract from competitive forces – effective competition relies on consumers being able to compare all package prices, but with costs involved in learning package prices, consumers are less likely to want to search for information on all package prices from all airlines, hindering their ability to compare. This gives airlines market power as it allows them to charge more than they would be able to in the presence of effective competition.  Naturally, the higher the search costs, the lower the willingness of consumers to carry out an additional search, and the higher the market power enjoyed by airlines.”

The Ministry of Civil Aviation is correct to ask for greater transparency – publishing a list of ancillary services along with their prices on the home pages of websites (for example) would significantly reduce the costs faced by potential customers in learning the final package price.

Conclusion

Whether or not unbundling will ultimately benefit the Indian consumer and whether base prices do eventually come down are things that time will tell.  The Ministry of Civil Aviation can, however, increase the likelihood of this move being successful by pre-empting attempts to sabotage the move by artificially increasing search costs.  In this regard, transparency and ease of access to information requirements would play a major role.

 


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