Paying more for airline passengers to give up seats

In a previous blog post about the mishandling by United Airlines of a passenger that had already boarded the plane, I suggested the following thought experiment: “Suppose United offered $10,000 to each person who gave up their seat. I suspect most passengers sitting on the plane would have volunteered.”

The next day, AP News reports that “Delta OKs offers of up to $9,950 to flyers who give up seats.”

This must be just a coincidence.

A United case for free markets and clearly defined rights

A lot has been written and said about United Airlines and their mishandling of a problem of overbooking. In case anyone missed the story, a United Airlines flight was overbooked. The airline also needed to fly crew members to the plane’s destination. The airline asked for volunteers to give up seats and even offered some money as an inducement, but that wasn’t enough. So the airline randomly selected passengers to remove involuntarily. Three agreed to leave the plane but one refused. The airline called airport police, who forcibly removed the passenger. Photos and videos of the passenger being dragged out of the plane caused worldwide criticism of the incident and airline. There are numerous memes floating on the internet now inspired by the event.

I am not going to criticize the airline or defend it. Others are doing that. However, I think the story provides an ideal case for illustrating two important economic principles: the superiority of free markets and the importance of clearly defined property rights.

First, economic systems determine how scarce resources are allocated. There are different ways of doing this. One involves free markets, where the exchange of money determines how resources are reallocated. Another involves various forms of command and control, where government or other entities dictate who does what and what goes where.

The airline had (some may say created) a problem of scarcity. There were more people who needed seats than there were seats available. A free market solution to the problem is simple: offer enough money to induce people to voluntarily give up their seat. Here is a thought experiment. Suppose United offered $10,000 to each person who gave up their seat. I suspect most passengers sitting on the plane would have volunteered. The airline said it offered compensation (the WSJ article linked above states that the airline offered up to $1,000). Clearly, the airline did not offer enough. In a free market environment, if the buyer values the resource more than the holder of the resource does, then an efficient exchange can occur if the buyer offers more than the seller’s value. If it was worth more than $1,000 a seat to United to get a crew member on the plane, then the airline should have offered more. If it was not worth more than $1,000, then the airline should not have pursued the matter further. That is the simplicity of the free market.

When there is command and control, such as when the government decides who flies and who doesn’t, then the government uses the power of the state to enforce its preferences, which we saw clearly here when the airline utilized police to drag an unwilling passenger off the plane. If the airline had utilized market principles, then there would have been no incident worth reporting. Stated differently, when markets function well (and when they are allowed to function well), then there is almost never a story to report. I find that interesting.

Second, when there is confusion about property rights, then there will be conflicts. People who buy plane tickets, either with a seat assignment or who are sitting in a seat, believe they have rights to the seat on the plane. In contrast, airlines not only can overbook but also can involuntarily deny boarding of passengers and even tell passengers they have to get off the plane, suggesting the airline believes it has rights to the seat on the plane. (Anyone interested can read United’s Contract of Carriage document here, especially rule 25, which describes what the airline’s obligations and rights are with respect to “denied boarding compensation”).

Regardless of whether passengers or airlines actually own rights, it is the beliefs they hold that matter most here. If passengers believe they have rights to the seat and if airlines believe they control those rights, then there will be a conflict when there is a problem of overbooking (that is, economic scarcity). Markets won’t work well here because there is no basis for determining who should pay and how much, since there is uncertainty about who initially owns the right to be transferred. If the airline believes it has the right, then it doesn’t need to offer any compensation. It can just drag unwilling passengers off the plane and place other passengers in the vacated seats.

The Nobel winning economist Ronald Coase described this problem and pointed to a solution: make clear who has rights to the seat. According to the Coase Theorem, bargaining is efficient when property rights are clearly defined and when bargaining is reasonably feasible. Airlines have demonstrated that bargaining for overbooked seats can work if they just offer enough compensation, suggesting they effectively acknowledge the beliefs of passengers that passengers hold rights to seats they have paid for, regardless of what their overbooking rules say.

The lesson here is therefore simple. If airlines are going to overbook their flights, then they should be prepared to pay passengers enough to induce volunteers to vacate their seats on the plane.

Economic models, high-priced consultants and ethical analysis

A colleague sent me a ProPublica article that explains how some “professors make more than a thousand bucks an hour peddling mega-mergers.” That’s a lot of money, even by consulting standards. MBA business consultants can charge between $200 and $600 an hour. Top partners in consulting firms might charge between $800 and $1200. A Wall Street Journal article in 2011 reported that top lawyers charged as much as $1000 an hour. But some economists are pulling in $1300 an hour as consultants.

To be fair, in a free market buyers and sellers should be able to negotiate for exchange prices. If someone is demanding $1300 an hour for their services and another is willing to pay it, then there is nothing objectionably wrong about the arrangement.

In this case the economic consultants are hired by firms that want to merge with or acquire other companies. The consultants are tasked with building a strong case, based on solid and objective economic principles and evidence, that the merger is in the interest of the industry, business, consumers and everyone else. What makes the article interesting is not that there are high priced economic consultants. It is that these consultants often get the antitrust analysis wrong. They build the arguments on speculation. They ignore or trivialize inconsistent or contradictory evidence. They use “junk science,” in the words of a Justice Department official quoted in the article.

A cynic might say that companies are paying the economists whatever price they will accept to argue whatever the company wants them to say, regardless of economics. Apologies to my lawyer friends, but isn’t this what lawyers do? So economists are on the same level as lawyers now?

Economics is a science. And economic models, when used appropriately, can provide a degree of objective assessment. The subjectivity comes in determining which economic models to use and what evidence to incorporate into the analysis. The ethical problem arises when the prospect of financial gain (in this case, a $1300 an hour contract) influences which models and what evidence to utilize. As noted by the authors, “The government’s reliance on economic models rests on the notion that they’re more scientific than human judgment. Yet merger economics has little objectivity. Like many areas of social science, it is dependent on assumptions, some explicit and some unseen and unexamined. That leaves room for economists to follow their preconceptions, and their wallets.”

The implication is that government regulators might be convinced a proposal is best for stakeholders (notice I didn’t use the word stockholders) when it is really only in the interest of the company seeking the merger–and comes at the expense of other stakeholders. In the case of a proposed merger between cell phone companies AT&T and T-Mobile, the economic consultant wanted to make this argument: “That even though prices would have risen for customers, the companies would have achieved large cost savings. The gain for AT&T shareholders … would have justified the merger, even if cell phone customers lost out.”

Let’s hear it for the economists.

When is an increase in price fair?

In my previous post I wrote about the fairness of drug companies that dramatically increase the price of their products. I suggested, and public reaction confirmed, that these price increases are considered unfair.

When is a price increase fair? When is it unfair?

The economic principle of profit maximization tells us that firms ought to increase prices when there is an increase in demand or a decrease in supply, regardless of whether the change is short-term or permanent. So if a hurricane is closing in on the East coast of the U.S., then suppliers of lumber, bottled water, gasoline and other supplies that people will need should and will increase the prices of these things … a lot. But is that fair?

Daniel Kahneman, Jack L. Knetsch and Richard Thaler published a paper on this topic 30 years ago in the American Economic Review. They argued that people’s perceptions of fairness will (or ought to) constrain impulses to take advantage of short-run increases in demand or other reasons to increase prices, under certain conditions.

Their discussion entails two elements. One has to do with reference points and the other has to do with reasons for gaining at the expense of others.

First, a reference point is the basis upon which people create expectations about the fairness of a transaction or a change in prices. If transactions or price changes are consistent with the reference point, then people will judge the transactions or price changes as fair. In other words, reference transactions and reference profits are considered fair. If there is a deviation from the reference point, then assessments of fairness will be made based on whether good reasons exist for the deviations.

The authors define the reference points as follows:

Market prices, posted prices, and the history of previous transactions between a firm and a transactor can serve as reference transactions. When there is a history of similar transaction between firm and transactor, the most recent price, wage, or rent will be adopted for reference unless the terms of the previous transaction were explicitly temporary. For new transactions, prevailing competitive prices or wages provide the natural reference.

For example, if a gas station has been selling gas for $1.99 a gallon for several weeks, then the reference price is $1.99 a gallon, and people will expect that to be the price the next time they get gas. If the price of gasoline increases, say to $2.09 a gallon, then people will likely consider the price increase unfair unless they understand there to be a good reason for the change. Good reasons have reference points, too. For example, raising prices at the expected rate of inflation is not considered unfair, since inflation-based price increases can be a reference point. We have historical experience with that, so there is no basis for claiming unfairness. The same about price changes in gasoline. If the reference point for price changes is 5 cents a gallon, then people won’t be bothered by finding the price of gasoline is higher by 5 cents the next time they buy gas. But if prices increase by more than 5 cents, then they might believe or expect something unfair is happening at their expense.

Understanding reference points for transactions, pricing and profits can help us understand why unfairness might be claimed when businesses increase prices. For example, if employees had previous experiences of getting pay increases when competitors raised their employees’ wages, then a reference point is created for employees. But if the employer has not historically increased wages when their competitors have, then the reference point for the employer will differ from that of the employees, resulting in disagreements about fairness.

Second, an important principle of fairness is that one should not gain by imposing a cost or harm on others.

Raising the price of lumber, bottled water, gasoline and other supplies that people will need when a hurricane is imminent can be considered imposing a harm on others to acquire a short-term gain. It doesn’t matter that economics dictates that price increases are needed to resolve shortages that will arise when there is a sudden increase in demand. There is usually no viable reference point for such behavior.

Raising prices because a business experiences an increase in costs is different. Such behavior is not considered as imposing a harm on others merely to benefit at their expense. Businesses are not gaining substantially, if at all, when they increase prices to cover their rising costs.

The implication is that people are willing to accept as fair an increase in price to cover rising costs. They also consider it fair for businesses to maintain prices when costs decline. But people consider raising prices when demand increases or without explanation or justification to be unfair.

Most people have no reference point for drug prices rising 5000 percent or even 500 percent. Such behavior is very unfair.

Because they can, but should they?

Mylan is the company that produces the EpiPen, a device that injects a measured dose of epinephrine when someone has a severe allergic reaction. Mylan didn’t invent the drug or device. The company acquired it in 2007 from Merck, which bought the rights for the drug years earlier from another company. By some estimates, Mylan’s EpiPen controls roughly 90 percent of the market for epinephrine injection devices. When Mylan purchased the rights to the EpiPen in 2007, the drug cost about $100 for a two-pen set. It currently retails for more than $600.

Mylan isn’t the only company to buy a drug and then dramatically increase its price. Earlier this year, the Wall Street Journal (as well as other news outlets) reported on pharmaceutical companies that buy rival’s drugs and then jack up the prices. A noteworthy example is Martin Shkreli, a hedge fund manager and CEO of Turing Pharmaceuticals, who bought the drug Daraprim and raised its price from about $13 a dose to $750. The drug is used to treat a variety of infections and other diseases. Turing bought the rights to the drug from a company, which bought the rights to the drug from another company, which bought the rights to the drug from another company, …

Why did Mylan increase the price of the EpiPen? Why did Turing increase the price of the drug Daraprin? Because they can. The companies control exclusive rights to the drug and the demand for the drugs are highly inelastic. First, by having exclusive rights over the drugs and with little if any competition, they possess monopoly power. This means they can act as price makers rather than price takers. Second, as I explained to my microeconomics students today, demand for the drugs is inelastic because there are few substitutes to them and they are necessary. This means that consumers will not (or cannot) be very responsive to large changes in prices. If you are subject to severe allergic reactions, you probably will not forgo the drug if its price increases. You will grumble and complain but buy it anyway. Thus, the combination of monopoly power and inelastic demand makes raising prices economically rational.

The drug companies and other commentator point to other reasons for high drug prices. Some argue that the patent system and long and costly regulatory approval processes are to blame. While these affect the initial costs for many drugs, they don’t explain why the price rose so quickly years after the drug has been on the market. If Daraprim was profitable at $13.50 a dose, then patenting and regulatory costs won’t explain the 5,000 percent increase in its price after Turing bought it.

According to an article in today’s Wall Street Journal, drugmakers are pointing a finger at middlemen for rising drug prices. Drug company executives say that the system is to blame. Everyone has to take a cut, such as pharmacy-benefits managers. Drug companies say that they have to offer increasingly larger rebates to pharmacy-benefits managers to induce them to accept their drugs as part of their company’s health plans. These benefits managers, in turn, are blaming drug prescription services and health insurers. While there might be some merit here, it’s hard to believe that middlemen and insurance companies are largely responsible for the dramatic increases in drug prices. I can’t imagine that a benefits manager will say “no” to the only drug that is available to treat severe allergic reactions or some infections. Drug companies won’t have to offer large rebate inducements if their drug prices were not already very high.

To be sure, the problem is complicated. Should we force drug companies to price their products “reasonably”? What is a reasonable price for a life-saving drug? Who’s to say that $20 or $30 or even $50 is unreasonable for Daraprim? These companies also employ thousands of workers and their stocks are part of savings, retirement and other investment portfolios for many people. If we mandate lower prices for drugs, then what happens to drug company employees and investors?

If drug companies can raise prices, and justify the price increases on economic grounds, then should they? Economic considerations are important, but they are not the only values that matter. Fairness matters too. Is it fair to ask patients to pay 5000 percent more for a lifesaving drug?

Fairness can be more difficult to justify than economic rationale. But we can simplify things. While there are many bases for arguing “fairness,” all of them are grounded in expectations. When our expectations are met, then we have little grounds for arguing unfairness. However, when expectations are not met, people typically feel justified in claiming unfairness. Consumers with a history and experience in paying $13.50 for a drug to treat infections will continue to expect that prices will be about the same the next time they buy the drug. While most people can expect gradual increases in prices, for instance due to inflation, there is no reasonable argument anyone can make that would convince me that consumers would expect a 5000 percent increase for Daraprim or a 500 percent increase for the EpiPen in a relatively short period of time. If drug companies want to increase prices more than what consumers expect, then the companies need to speak directly to consumers and change their expectations. That is fair. But I expect that will be quite a challenge for drug companies.



If you do not like your friends or do not have any close friends, should you be able to rent or pay someone to be a friend? Would you want to?

I teach an introductory microeconomics course. After discussing markets and teaching the basics of supply and demand today, I had a conversation with the class about the universal appropriateness of markets. Market, the price mechanism and the profit motive are great. When allowed to function, they offer quite a bit to society and largely account for our growing wealth and increased availability of goods and services, including advanced technologies we have come to enjoy and rely on today. However, do we want or need markets, the price mechanism and the profit motive dominating every aspect of our lives? Are there some things for which markets and prices should not be used?

I asked these questions and then showed a clip from the movie The Truman Show. In the movie, Jim Carrey’s character, Truman, is unaware that he lives in a movie set. His entire life has been displayed on TV. His wife and best friend are actors. The clip I show follows a scene where Truman has become suspicious about his existence. The show’s producer will stop at nothing to keep Truman on set, so he instructs Truman’s best friend, Marlon, to talk to Truman and convince him all is fine, with the words, “The last thing I would ever do it lie to you.” Is he really a best friend for Truman as a paid actor in the role of “best friend”? Should it matter to Truman? As outsiders watching the movie, do we care?

Michael Sandel, a Yale University philosophy professor, has famously written on this topic. See a TED talk he gave here. In his book, What Money Can’t Buy: The Moral Limits of Markets, Sandel writes,

“Today, the logic of buying and selling no longer applies to material goods alone but increasingly governs the whole of life. It is time to ask whether we want to live this way. … The most fateful change that unfolded during the past three decades was not an increase in greed. It was the expansion of markets, and or market values, into spheres of life there they don’t belong. To contend with this condition, we need to do more than inveigh against greed; we need to rethink the role that markets should place in our society. We need a public debate about what it means to keep markets in their place. To have this debate, we need to think through the moral limits of markets. We need to ask whether there are some things money should not buy.”

When I asked my students to give me examples of things they think money should not buy, many mentioned friends, family and love. These make sense. We want friends, family and love to be motivated by intrinsic considerations, not by extrinsic incentives. Money and other extrinsic incentives have a way of crowding out intrinsic motivation, a topic I have written about (here). Other students wanted markets out of education, insurance, health care, and some specifically mentioned textbooks. I can understand their frustration with textbooks, some of which are very, very expensive. But would education, insurance and health care be improved if markets were removed and providers and consumers were only intrinsically motivated? What if we taxed everyone and had the government pay for these services, would that improve things? We do that with national defense, so how about these other considerations? Lest there be confusion, this is not a question about whether goods are public or private but whether money and markets should govern their functions.

If you don’t want to rent-a-friend or meet and talk with real people, then  consider the Tokyo Game Show. As reported by Yahoo! news, attendees can flirt with virtual women. Now, instead of paying someone to be your friend you can buy a machine who will talk with you and ask how your day went. Let’s hear it for the power of market incentives.