Competitive response to unbundled services: An empirical look at Spirit Airlines

Abstract

In 2010, Spirit Airlines announced that it would start charging passengers for carry-on baggage. Using a vector of route-level characteristics, we construct a matched group consisting of routes which best match those served by Spirit (the treated group). We then run a difference-in-difference estimation using the treated and matched group, and examine the impact of Spirit's baggage fee policy on its rivals' ticket prices. Our results show that Spirit's rivals reduce their prices by about 5.8% after Spirit charges carry-on baggage fee. We also look into potentially heterogeneous responses across different types of rivals. There is no significant difference in how low-cost carriers and legacy carriers respond to Spirit's policy change. However, relative to non-subcontracting carriers, those which subcontract operations to regional carriers reduce their prices further by more than 10%, including average prices (linear or log) and various other points on the price distribution. We also develop a stylized theory model to help better understand our empirical findings. | INTRODUCTIONPrice unbundling, where charging all-inclusive prices is replaced by a business model of lower basic price plus additional fees for add-ons, has become a strategic tool for firms to boost revenue. For example, hotels are known to collect fees for various services, such as early check-in, Wi-Fi, mini-bar, parking, and gym. Rental car companies often charge for Global Positioning System (GPS) navigation systems, child seats, additional drivers, mileage, early return, drop-off at different locations, and changing rental times or dates. Similarly, the practice of freemium is often observed for digital products, and on app store many apps are available for free with in-app purchase. The US airline industry, which we study in this paper, has experienced a significant increase in price unbundling in recent years as well. Examples include baggage fees, premium seats upgrade, and so forth. Airlines have also found new sources of revenue from services, such as Wi-Fi and Entertainment. Most major airlines started charging for checked bags back in 2008, and in 2017 United and American started selling Basic Economy fares for which travelers need to pay extra to bring a carry-on baggage or pick a seat. 1 Increasing reliance on ancillary revenue by airlines makes it crucial to understand the impacts of airlines' add-on pricing strategies.Carry-on baggage fee is one of the high-priced add-on items. In April 2010, Spirit Airlines (hereafter Spirit) announced that it would charge travelers $20-45 for a carry-on baggage. 2 While multiple carriers had started charging for checked baggages, Spirit was the first carrier to charge for carry-on baggages, and the only one doing so until Frontier and Allegiant followed Spirit's step in 2012 and 2014, respectively. More recently, legacy carriers also started offering basic economy fares, which put restrictions on carry-on baggages among other things.

Mergers and organizational disruption: Evidence from the US airline industry

“…Borenstein and Netz (1999) study how competition affects departure time differentiation both before and after deregulation. He et al (2022) investigate how a change in the terms of service of one airline impacts equilibrium prices. Mazzeo (2003) studies the relationship between competition and on-time performance, presenting evidence in favor of more frequent and longer delays on routes with only one airline providing direct service.…”

Subcontracting Network Formation Among U.S. Airline Carriers*

“…shows that a learning mechanism affects the link formation in the network of interbank credit relationships.3 The exploration of subcontracting/outsourcing is motivated by a need to understand makeor-buy decisions and has been the subject of study in various settings and industries besides the airline industry, such as entertainment, health care and public service(De Silva et al [2012a];Marion [2009]). 4 DeSilva et al [2012bSilva et al [ , 2017 study the effect of subcontracting on the survival and business duration of firms in government procurement projects.5He et al [2021] study how subcontracting carriers respond differently from nonsubcontracting carriers to an external negative price shock.6Boguslaski et al [2004] study the entry patterns by a specific airline, Southwest.…”