With fuel costs plummeting, why haven’t airlines dropped ticket prices? After all, airfares rise pretty quickly when gas prices rise. And 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. Fixing broken markets is my favorite topic over at BobSullivan.net.
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 relief at the pump. But that’s nothing compared with the $5 billion that American Airlines says it will save this year, thanks to lower gas prices. What’s happening to that windfall?
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 served by only two or three 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 are only two, 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.