05/24/2010 10:51 am ET | Updated May 25, 2011

The Pros and "Cons" of Hidden Airline Fees

It all started with the olive. Back in 1987, American Airlines became a pioneer in the declining amenities trend by eliminating olives on salads in order to slash costs by $40,000 per year. This trend re-emerged around 2005, when airlines started taking away free pillows, magazines and even pretzels for coach passengers while competing heavily on service for business and first-class passengers. In June 2008, American and United Airlines announced that they were going to introduce fees for all checked baggage, and low-cost carries such as Spirit Airlines followed suit if they had not been doing so already. In September 2009, Southwest Airlines committed the ultimate customer service sin by taking away lemons as a beverage garnish. (Actually, this wasn't necessarily a terrible idea, since the very scientific polls conducted seemed to indicate that people don't really like lemons anyway.) In April of this year, Spirit Airlines started charging from $20-$45 for carry-on bags, and the company's CEO even went so far as to justify the decision by explaining that the company was trying to improve customer service by giving customers a disincentive to bring carry-on luggage and thereby reducing security delays. (In case you were curious, he neglected to mention that it was the checked baggage fees that likely exacerbated the delays in the first place.) Lastly, in a fun twist, Ryanair actually made those "what next- are they going to charge us for use of the restroom?" jokes a reality when it announced that it was going to reduce the number of lavatories and install coin-operated locks on the doors.

So what gives? Are the evil corporations unfairly taking advantage of poor, defenseless consumers? Yes...and no.

On the no side, some of the reduction in amenities is more consumer-driven than it might initially appear. In order to make it worthwhile for airlines to provide features such as pillows, pretzels, olives or lemons, customers have to be willing to pay more for them than they cost to provide. If consumers are only paying attention to price when making their purchasing decisions, what incentive is there for airlines to compete on service? Various travel sites make it very easy to compare flight prices, but, for the most part, they don't provide information on the differing service levels of the airlines. This makes price the salient differentiating factor, so it's not surprising that consumers are essentially requesting price-driven competition.

The other part of what is taking place in the airline industry is a form of piecemeal versus all-inclusive pricing. In a lot of cases, airlines aren't taking away amenities such as in-flight meals, entertainment, and baggage handling, but they are no longer including them in the price of the flights. With all-inclusive pricing, customers who use fewer services end up subsidizing the heavier users, since everyone is charged the same price and the company has to make an overall profit. In addition, there is potential for moral hazard with all-inclusive pricing, since people consume more services when they are "free" than they would if they had to pay for them individually, but these services usually aren't free for the company to provide. The company, therefore, must take moral hazard into account with an all-inclusive pricing scheme, which makes customer expenditure and airline costs higher overall than they would be with piecemeal pricing. For example, I've often taken free beverages on a flight even though I didn't really want them, mostly because they were there and didn't cost me anything, but that cost was factored into the ticket prices of both myself and my fellow passengers. What the airlines seem to be saying is that it is profitable for them to implement piecemeal as opposed to all-inclusive pricing for their flights and related services. This strategy is reasonable, and even more equitable for consumers, when there is substantial variation in the utilization of the services and/or significant potential for moral hazard.

On the yes side, airlines are exploiting the fact that consumers are generally more sensitive to price increases than they are to decreases in quantity or features. (Social science research has evidence of this phenomenon, and it seems to be pretty prevalent in the grocery industry.) They are also setting up piecemeal pricing for items that have little variation in usage and little potential for moral hazard, such as checked and carry-on luggage. (I doubt that people vastly overpack when they don't have to pay extra to take a bag with them.) These characteristics imply that the a la carte baggage fees should be more trouble than they are worth, but they are likely a profitable strategy since people generally act like, well, people and not economic robots.

Economic robots, for example, will analyze how many bags they will be taking with them, whether they will want a beverage and/or pretzels on board, and how important an airline pillow is to them, and they will make their choices regarding which flights are the best value accordingly. Humans, on the other hand, will likely realize that it prohibitively cumbersome to find and compare all of the different costs when choosing a flight and just go with the one that Orbitz says is the cheapest. Again, if this is how customers are choosing their flights, then airlines have an incentive to structure their pricing with a lower dollar number on the flight itself and a higher dollar number on the "extra" services, since customers won't fully internalize the a la carte prices until after they've already purchased their tickets.

This last point seems to be what has drawn the ire of Transportation Secretary Ray LaHood and Senator Chuck Schumer, and not without reason. Economists realize that information gathering isn't costless, and, by structuring the pricing in an unnecessarily complicated way, the airlines are effectively adding to the cost of the flights above and beyond the dollar amount on the tickets. They are also causing people who aren't paying enough attention to the fine print to make potentially unwise economic decisions.

The reality of the matter is that transporting one's self on a flying vehicle isn't cheap, and airlines need to cover their costs in order to stay in business. In some ways, consumers need to appreciate this fact and not blame the airlines for having to raise prices and cut flights in response to increases in fuel costs and the like. The flip side of that argument is that if airlines want people to trust them to simply react to market forces and not abuse their market power, they might want to stop with the artificial hiding of fees, since those sorts of behaviors don't exactly inspire consumer confidence.