A Plane Idea: Make the Airlines Suffer

Fortune issue: July 10, 2000

First Principles

A Plane Idea: Make the Airlines Suffer

By N. Gregory Mankiw

The public seems to view the latest wave of airline consolidation with skepticism. Rightly so. Airlines are hardly the economy's most loved industry, and with fewer players, there are reasons to think service will suffer while ticket prices rise. But I've figured out a solution that would cut back on delayed flights, missed connections, and lost business opportunities: Make the airlines suffer rather than the passengers.

This epiphany came to me as I traveled with my wife and three small kids to a few days of rest in Jamaica. Our flight was delayed with mechanical problems, delayed again, and again, and then canceled. In the end, American Airlines delivered us to Jamaica 24 hours later than scheduled. "It's unfair," my 8-year-old daughter told me. "They should keep an extra plane around in case the first one breaks." Finally! A chance to teach my daughter some basics in economics. As we waited in an airport, I played economist-father, explaining costs and benefits to my daughter. Yes, I said, an extra plane would save us this inconvenience, but extra planes are expensive. Perhaps, when everything is added up, the benefit did not justify the cost.

But then it hit me: No one has any incentive to do this calculation. My family and I were painfully aware of the cost of the delay, but we couldn't do much about it. The airline can reduce delays by keeping more extra parts, mechanics, and planes, but why should it? It bears only a small fraction of the delay's cost. In our case, it picked up the tab for a night at an airport hotel, but an American representative told us the airline wouldn't pay for the lost day at the prepaid Jamaican resort. I didn't even ask about the biggest cost - lost vacation time.

One big principle of economics is that incentives matter. This means that people should bear the costs of their actions. If the EPA doesn't fine a paper mill for emitting too much pollution, the mill will do as it pleases. If airlines don't bear the full cost of travel delays, they experience too many. Put simply, airlines aren't sufficiently motivated to make sure travelers arrive as scheduled. The solution? Make them pay. Economists say we should clean up the environment by taxing polluters. We can fix the airline industry by forcing it to compensate travelers for delays.

Here's how it would work: The FAA would estimate the value of time for the typical traveler - say, $20 per hour. Then whenever a flight arrives late, the airline would pay passengers for their time as they got off the plane. A family of five arriving 24 hours late, for instance, would be handed a check for $2,400.

This plan would raise the price of air travel, as airlines passed on higher costs to consumers. Yet the hike would be offset by the automatic travel insurance that would come with each ticket. More important, carriers would be motivated to be more responsible. If an airline took precautions to avoid delays - if it kept an extra plane handy, as my daughter suggested - it would reap the benefit of lower late fees and gain passenger goodwill. Airline executives would have an incentive to do the rational cost-benefit calculation that someone somewhere should be doing but that no one under the current system does.

A lawyer might call these late fees "liquidated damages" for the airline's breach of contract. Such clauses are common in contracts for commercial construction, which often penalize contractors for delays. No one could individually negotiate this type of deal, but a public-spirited FAA could require it on behalf of all consumers.

Of course, there is another solution to the problem of flight delays. My family and I are spending our next vacation in Nantucket - and this time we're taking the ferry.


N. GREGORY MANKIW is an economics professor at Harvard and the author of Principles of Economics.