Do Frequent Flyer Programs Reduce Economic Efficiency?

Tim Harford, whose writings I usually much like, explores whether frequent flyer programs are inefficient for the economy. He’s right to suggest that they create product differentiation among air carriers that might otherwise be commodity products. And as differentiated products, consumers have preferences (driven by value created by the program’s loyalty program)>

Certainly in the context of business travel, employees with a preference for air carrier may make a choice that’s different from what’s in the best interest of the employer.

That’s sometimes true. Agency problems exist any time someone is spending another person or entity’s money.

On the other hand, the personal benefits from frequent flyer programs make business travel much more palatable. Employees with elite status fly relatively hassle-free, aren’t charged checked baggage fees that they’d otherwise expensive, often receive meals in first class instead of buying food and billing the company. And they’re more willing to take on the flying that benefits their employers because of this treatment. They get priority on waitlists, help during irregular operations, and are more likely to make their meetings and waste less time along the way. Much better for employer productivity.

Moreover, the employees are getting compensation from the frequent flyer program (in the form of free future travel) in exchange for their business trips instead of from their employers. It’s as reasonable as Harford’s assumptions to believe that without the ‘kickbacks’ from frequent flyer programs, that employers would have to compensate their employees more to take on high volume business travel.

Harford suggests that frequent flyer programs “artfully create what economists call “switching costs”, by offering employees an incentive to stick with an individual airline.”

And there are elements of this, but it fails to understand the specific industry behaviors that have developed by competitive firms to offset this effect and encourage customers to switch carriers.

Sure, an elite member of American Airlines AAdvantage wants to stick with AAdvantage because of their elite benefits. But Continental realizes that the customer is a valuable one, and that it’s difficult for that customer to switch. So Continental will ‘match’ the elite status of that American Airlines customer with status in their own program on request. (This is usually a once in a lifetime proposition, and nearly all U.S. programs offer some form of status match or expedited status program.) Boom, switching costs due to elite status gone.

When frequent flyer programs began they realized that a depleted account meant a customer might leap to a competitor. It was commonplace for a carrier to award, say, 5000 miles to a customer who depleted their account so that there’d be reason to continue accruing in that program.

That’s no longer the case, and likely reasons why. Having mileage balances in a particular program hardly create switching costs. A member reaches a mileage threshold and receives a free trip. Account depleted, no more switching costs. Customers don’t even need to stick with their existing carrier in order to continuing accruing miles up to the point they have enough to redeem. More than half of miles are earned from sources other than flying, a customer might charge some more to their credit card or credit some hotel stays to an airline program.

Finally, Harford’s claim that frequent flyer programs drive up price seems to run counter to empirical facts — that prices are far lower on an inflation-adjusted basis than they were before the introduction of such programs.

Frequent flyer programs are both a marketing expense and in and of themselves a profit center. In most cases they are the most profitable part of an airline. They drive business to the airline and to their partners who buy miles from the carrier. And they generate consumer value, customers use them to access not just flights which replace those they’d otherwise purchase for cash but travel they would never otherwise be able to experience — a middle class collector of miles who flies in flat bed first class offerings with good champagne, caviar, and complimentary airport limousine transfers. Miles are the great democratize of travel.

About Gary Leff

Gary Leff is one of the foremost experts in the field of miles, points, and frequent business travel - a topic he has covered since 2002. Co-founder of frequent flyer community InsideFlyer.com, emcee of the Freddie Awards, and named one of the "World's Top Travel Experts" by Conde' Nast Traveler (2010-Present) Gary has been a guest on most major news media, profiled in several top print publications, and published broadly on the topic of consumer loyalty. More About Gary »

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Comments

  1. I agree. Nicely written.
    For those who hate frequent flyer programs, just one small reminder: “you don’t have to participate”.
    😉

  2. Actually, Harford’s arguments are perfectly sensible and yours are fairly specious.

    First, the switching costs are real. You may be able to use status matching to switch programs once in a while, but if you’re a UA elite, you aren’t going to fly AA on SFO-JFK for the one-time trip when AA happens to be $100 cheaper unless your employer forces you to do so.

    Second, the argument that compensation is coming to frequent business travelers from the frequent flyer program and not the employer and that this somehow saves the employer money is true for a single employer, but in the alternative world where frequent flyer mile accumulation was forbidden by law, it seems clear that tickets would be cheaper; that would save money.

    Third, if employers want to buy more comfort for their employees, they could just buy it directly, now that these things are increasingly unbundled. That would be more efficient than doing it through miles.

    Fourth, miles are tax-free compensation, so they also contribute to tax evasion. Nobody likes paying taxes, but it’s not clear what economic theory would say that frequent flyers deserve a tax break as opposed to any other group of people.

    Fifth, the argument that fares have fallen substantially since the introduction of frequent flyer programs is a non-starter. A whole bunch of other things changed at essentially the same time (deregulation, anyone? hub-and-spoke structure, anyone? LCCs, anyone?) and you don’t even try to identify these separately. (Fair enough, too – it would be hard, but your point is not logical when theory, as Harford explains, strongly points the other way.)

    Last, why do you think ‘miles are the great democratizer’? It’s price discrimination, pure and simple. Companies don’t buy tickets with miles, and people with a lot of money and not much time to worry about the details of frequent flyer programs. Therefore, someone paying with miles is identifiably a more price-elastic consumer than someone paying with cash. Therefore it’s optimal to charge them less. So, I agree that airlines have a strong incentive to use a mileage program to dump distressed inventory without damaging high cash last-minute fares (for example). But this doesn’t require that miles be earned through flying, which is the part that is anti-competitive. If miles were earned only through credit card accumulation and all the other ways other than travel that loyalty programs now mint miles, that would be just fine.

    And, Lantean, your argument also makes no sense. It’s (roughly) a prisoner’s dilemma. If nobody participated in frequent flyer programs, the economy as a whole would be better off. Bu if everyone else participates, it’s a dominant strategy for you to participate too. You can think that frequent flyer programs are a terrible thing, like I do, and still eagerly participate.

  3. I don’t really find this topic interesting, so I won’t write an analysis or anything like that, but I do want to nitpick your analysis of “economic efficiency”.

    When someone argues that an economic institution (such as a frequent flier program) is efficient (or inefficient), they ought to evaluate “efficiency” within a broader context of general welfare. I.e., not within the context of “does it further the profits of the traveller’s employer” or “does it create agency problems”. To be sure, those are good questions on their own, but but they’re not what “efficiency” means in general–you were just exploring the question of whether frequent flier programs are efficient from the perspective of an employer, not from that of society as a whole.

  4. @William, you write:

    “the switching costs are real. You may be able to use status matching to switch programs once in a while, but if you’re a UA elite, you aren’t going to fly AA on SFO-JFK for the one-time trip when AA happens to be $100 cheaper unless your employer forces you to do so.”

    As I explained, the mileage programs mean the products are more differentiated. It’s not simply a matter of equivalent commodities. And it doesn’t always make sense to take the one-time cheaper flight when status benefits are factored into the equation, the elite status customer may come out ahead even spending $100 additional on occasion.

    “in the alternative world where frequent flyer mile accumulation was forbidden by law, it seems clear that tickets would be cheaper; that would save money.”

    Why? I dealt with this in a recent post. Frequent flyer miles are effective marketing, airlines would have to spend on next best marketing which would likely take more dollars to yield same result. Industry costs would be higher, not lower, wouldn’t this generate higher prices over time?

    “if employers want to buy more comfort for their employees, they could just buy it directly,”

    It’s more expensive to do so.

    “miles are tax-free compensation, so they also contribute to tax evasion.”

    Sale of miles by airlines to their partners such as credit card companies are taxed, generates billions in tax revenue. More miles are earned from non-flying activity than flying activity.

    Mileage programs are the most profitable part of major airlines, many are flying today that wouldn’t have otherwise continued to operate because of those programs. Airline tickets are among the most heavily taxed products in the US. Total tax revenue is certainly higher as a result of mileage programs.

    And it’s hardly tax evasion to say that there are activities which are untaxed in law.

    “Nobody likes paying taxes, but it’s not clear what economic theory would say that frequent flyers deserve a tax break as opposed to any other group of people.”

    Airline travel is more heavily taxed than most activities already, it’s complicated, hardly a clear government subsidy here but that’s far beyond the scope of this discussion.

    “the argument that fares have fallen substantially since the introduction of frequent flyer programs is a non-starter. A whole bunch of other things changed at essentially the same time (deregulation, anyone? hub-and-spoke structure, anyone? LCCs, anyone?) and you don’t even try to identify these separately. (Fair enough, too – it would be hard, but your point is not logical when theory, as Harford explains, strongly points the other way.)”

    Of course other drivers of falling prices, my argument is not that mileage programs hold down price. Rather it’s certainly not obviously the case that prices are HIGHER as a result of mileage programs when prices are falling, and certainly no evidence to suggest it.

    “Last, why do you think ‘miles are the great democratizer’?”

    Because plebes like me can access luxury travel well beyond what would otherwise be available. You call it price discrimination but to some extent that’s exactly the point, the programs create the mechanism that makes this possible.

  5. I think that the issue is more one of agency than economic efficiency. Personal benefits accrue to the traveller, but someone else pays for this. If the traveller has any influence over the choice of airline then he is liable to be corrupted. This corruption can come via, for example, persuading the payer to choose a particular itinerary (perhaps through specious arguments about convenience) which is more expensive, or collecting remuneration (miles) which are untaxed, or even making more trips than are strictly necessary. All of these direct assets towards the traveller and away from the payer of the taxman.

    This may or may not be efficient for the economy at large: Gary would argue it is, Tim Harford and William would say not. However, it is not the only example of this. Consider the employee who puts all his (perfectly legitimate) expenses on his credit card to earn cash back: here there appears to be no cost, but retailers generally absorb that cost in extra card processing charges and pass it on to all customers. How long before that customer becomes so addicted to cash back that he is tempted to charge a little more than strictly necessary?

    Also, I don’t buy the argument that people need more money because they have to travel – the vast majority of people I know who travel regularly on work love it (even if they moan): conversely many of the desk-bound would love to get away from the office on a regular basis.

    So I conclude that, in an ideal world, miles and other benefits should only be permitted to accrue to the payer – but, in terms of priorities for an ideal world, this would rate fairly low!

  6. Hi everyone,
    interesting discussion on the tax aspect of redemption awards. if the companies (principals)really paid too much in travel expenses because employees (agents) do the wrong thing by being swayed to buy higher priced airfares to get FFP points…why would they not stop this? I do not buy the argument that they can’t.
    Any thoughts?
    Nat

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