Haas School of Business 10 Baggage Fees A Game Theory Perspective MBA211: Game Theory: Team Gardè Naveed ALAM, Gabriele BODDA, Gopi PAI, Punya SANDHUAirline Baggage Fees A Game Theory Perspective Page 2 Table of Contents 1. Introduction ........................................................................................................................................................... 3 1.1 The Airline Industry ...................................................................................................................................... 3 1.2 The Need for Additional Sources of Revenue .......................................................................................... 4 1.3 Baggage Fees ................................................................................................................................................ 4 1.4 Baggage Fee Collections.............................................................................................................................. 5 1.5 Latest Developments ................................................................................................................................... 6 1.6 Airline Terminology ...................................................................................................................................... 6 2. Analysis .................................................................................................................................................................. 7 2.1 Data & Assumptions ..................................................................................................................................... 7 2.1.1 Airline Data ............................................................................................................................................ 7 2.1.2 Assumptions .......................................................................................................................................... 8 2.2 Airlines vs. Passengers ................................................................................................................................ 8 2.2.1 Overview ................................................................................................................................................ 8 2.2.2 Numerical Assumptions ....................................................................................................................... 9 2.2.3 Look Forward Reason-Back Analysis ................................................................................................. 9 2.2.4 The 2-Staged Game ........................................................................................................................... 10 2.2.5 Key Take-aways .................................................................................................................................. 11 2.3 Airlines vs. Competition ............................................................................................................................. 11 2.3.1 Overview .............................................................................................................................................. 11 2.3.2 Defection Rate Analysis ..................................................................................................................... 11 2.3.3 Sequence of events ............................................................................................................................ 14 2.3.4 Look Forward Reason-Back Analysis ............................................................................................... 14 2.3.5 Charging for the 2nd checked in bag ................................................................................................ 14 2.3.6 Charging for 2 bags ............................................................................................................................ 16 2.3.7 Key Take-aways .................................................................................................................................. 17 2.4 Southwest’s Strategy ................................................................................................................................. 17 3. Conclusion ........................................................................................................................................................... 20 4. References ........................................................................................................................................................... 21 4.1 Airline competition in the US domestic market ......................................... Error! Bookmark not defined. 4.1.1 2008 Summary Financials (Table A): .............................................................................................. 22 4.1.2 2008 Summary Financials (Table B): .............................................................................................. 23Airline Baggage Fees A Game Theory Perspective Page 3 1. Introduction 1.1 The Airline Industry The airline business is notoriously difficult, besieged by volatile fuel costs, fare wars, unpredictable weather, complicated routing logistics, expensive equipment, and even the occasional volcano. The major defining characteristics of this industry are: - High fixed costs: The airline industry is highly capital intensive and therefore requires huge investments periodically. The 12 largest players operated a total of 3512 aircrafts, an average of almost 300 aircrafts. - Huge Fuel costs: Fuel constitutes the single largest expense item for this industry. In 2008, the average fuel expense as a percentage of revenue amounted to 41.71%. - Debt intensive: The industry is also marked by heavy usage of long-term debt, probably because of the huge investments required. The average long-term debt as a percentage of revenue in 2008 was 44.94% and long-term debt as a percentage of assets was 35.27%. Illustrating the whimsical nature of the industry is its profitability. Profitability in the airline industry has been elusive, with pretax profit margins highly cyclical and well below the U.S. corporate average: 1 The total U.S. fleet shrank by approximately 700 aircraft from 2000 to