Now you see it

Markets need institutions to help them work properly - things like a practically enforceable rule of law, well defined property rights, and the likes of our Fair Trading Act and 'weights and measures' provisions to prevent misrepresentation and deceit and to foster trust in commercial exchange.

All that orthodoxy said, the Fair Trading Act and its companions, worthy though they are, have never greatly floated my boat, and I'm relieved that it's someone else pinging (for example) the back-of-a-truck ratbags selling overpriced tat to poor people.

But during the week I came across an interesting new piece that raised my opinion of the impact Fair Trading enforcement can have. It's from the States, and it looks at the impact of making the airlines disclose the full price of tickets, including all taxes.

By way of background, we don't have rules that require all-inclusive pricing. Back in 2012 when consumer law was being updated, the Commerce Commission argued for all-inclusive pricing to be mandatory, as it is in Australia. MBIE however didn't see an issue, so the Commission's proposal died the death. A pity: I have a lot of sympathy for Consumer New Zealand and its "sneaky fees" campaign. As they say here,

our research shows the problem is real and, with the rise of online trading, looks set to get worse. When goods and services are bought online, we’ve found extra fees may only be revealed near the end of the purchase process.

Not only does the practice mislead consumers, it also makes it difficult to compare prices and gives the retailer an unfair advantage over companies that are upfront about costs. All-inclusive pricing rules would ensure consumers can easily identify the price of a product.

What I didn't know, before I read this American research, was how big the impact of fully disclosing the total price might be.

The paper, published last month, is 'Hidden Baggage: Behavioral Responses to Changes in Airline Ticket Tax Disclosure', and was published in the discussion paper series of the Fed. I came across it, by the way, thanks to the very useful Brookings Briefs which trawl for interesting papers across a variety of issues. Here's what happened.

From early 2012, the US Department of Transportation brought in "full fare advertising rules", or FFAR, which required airlines to show the ticket price including various flight-specific taxes that had previously not been shown until you went to pay. Finding out what those taxes were, by the way, was very difficult in the pre-FFAR regime, assuming you even knew that there were extra taxes and that they varied quite a bit from flight to flight.

On the very large database of  international flights the two authors looked at, the average price was US$750 and the taxes were a sizeable $100, with quite a lot of variation (standard deviation of $45). As the authors show (on pp7-8 and in Table 1) it would have been very easy to pick a flight that looked cheap on a pre-tax basis, but which turned out to be an expensive option on a full-disclosure basis.

And what happened when buyers could see the full price?

First of all, consumers ended up wearing much less of the taxes, and the airlines absorbing much more of them. This is the bit of tax economics known as "incidence", which looks at who actually ends up paying taxes (or receiving subsidies), as opposed to who formally pays them - they can be quite different. You might think, for example, that subsidies to first home buyers will go to the formal home buyer beneficiaries: typically, they won't, and will actually be trousered by housebuilders.

In this case, pre-disclosure, the airlines correctly reasoned that what you can't see or can't be bothered about, we'll dump entirely in your lap. Post-disclosure, consumers were more sensitised, and to keep their custom airlines had to sharpen their pencils and cut their base fares. Or as the paper says (p21)

Three-quarters of every dollar in ticket taxes are thus borne by the airlines in the post-FFAR period, in marked contrast to the pre-FFAR period when  consumers bore the entire tax.

The researchers also found, by the way, that the pattern of pass-through varied with how competitive the route was. If there were lots of competitors (as measured by a lowish HHI index) pass-through by the airlines was higher, which is what theory predicts (low profit margins in a competitive market don't leave much room for sellers to absorb costs in base prices). And it was lower in low-competition markets: "Following the adoption of tax-inclusive pricing ... pass-through rates for unit taxes are shown to drop most sharply in more highly concentrated (i.e. "duopoly") markets" (p28).

Consumers also wised up. Before FFAR, they could see base fares (disclosed), non-tax charges (disclosed) but not ticket taxes (undisclosed). They reacted as you'd expect to the first two (buying less when the cost went up), but paid little or no attention to the taxes, which, as noted, they consequently ended up wearing. Post FFAR, they became sensitised to all elements of the cost:

Adoption of FFAR, however, is associated with significant de-biasing [i.e. responding to all components of costs the same way], such that when base fares, unit taxes, and non-tax charges are all included in total fares in an equally salient [transparent] manner, consumers respond to each equally - consistent with the standard theory of (attentive) consumer behavior (p23, square brackets are my explanation of some of the terminology)

The airlines got hit in a couple of ways. They had to cut base fares to accommodate their new share of the taxes, and were faced by more price-sensitive customers. All up, it made quite a big difference:

The combined impact of reduced ticket tax pass-through and reduced passenger demand (in relation to the portion of the tax still born by consumers) together imply that a $5 increase in unit taxes is furthermore associated with a 2.4% reduction in airline ticket revenue (p30)

As the authors say, "These represent large potential losses in ticket revenue ... and lend strong justification for the U.S. airline industry's intense and persistent efforts to reverse FFAR through lobbying and public relations campaigns" (p26). Best I can tell, a Bill which includes a provision to reverse FFAR has got through the US House of Representatives, but hasn't yet got through the Senate. In Trump's America, though, if you're an airline CEO, you've got to fancy its chances of going all the way.

Maybe the airlines weren't hit as badly as they looked: "it is also possible that carriers may have compensated for lower base fares and ticket revenue through increased reliance on product unbundling and the use of less heavily regulated add-on fees, such as baggage and check-in fees, seat upgrades, in-flight meals and service, etc., whose costs to consumers we do not observe in the ticket data" (p26).

If so, mandating FFAR (and full price disclosure more generally) in New Zealand "should be tempered by the possibility of fostering unintended consequences" (p30) like extra fees for this, that and the other. Me? I'd go for it. These are big bucks being transferred from consumers to producers solely because of off-the-radar treatment. Looks to me as if efficiency and equity point the same way.

As a final thought, it was great to see empirical methods being applied to an issue like all-inclusive pricing. It's all very well running in-principle arguments before Select Committees, but facts are trumps. Big data got by, for example, 'scraping' online prices (as in this paper), are increasingly going to inform what otherwise would be semi-philosophical debates. About time, too.