business subsidies

Our Strange Economy: How Coffee Shops Subsidize Airlines

February 6, 2021

 

Ian Tidswell provides insight into the strange pricing practices fueled by loyalty programs, credit card programs, fees, and customer perception of value. 

Utpal Dholakia always has interesting posts on pricing.  This one got me thinking about the strange way that buying a coffee can result in wealth transfer to an airline.  

Airlines make a lot of money off of their loyalty programs (often all of their profit). 71% of those miles are purchased, many by banks for their credit card programs.  This is strange.

Credit card payment processing is not a very economically efficient market: there’s close to a duopoly with MasterCard and Visa (80% market share).  That, along with the scale efficiencies, consumer switching costs, and merchant risk aversion (more on this below) mean they can charge high fees to merchants, capturing huge value.  (Capturing rather than creating IMHO, since this is rent-seeking behavior. It’s a high-margin, commodity business. MasterCard net profit margin is 50%!)

MasterCard and Visa member banks then compete with each other in a profitable but near-commodity market. One way they compete is on price: sharing some of the fees they earn via the processing companies with consumers. They could do this with a simple cash-back scheme or other reward programs, but it turns out that airline loyalty points work well since many people value them higher than their actual worth. It’s basically a parallel currency with a highly variable exchange rate to valuable services. An exchange rate the airline controls.

 

Key points include:

  • The true value of reward programs
  • The true cost of reward points
  • The rentier economy

 

Read the full post, The strange case of a Cup of Coffee, Credit Cards and Costa Rica vacations, and access links on the subject on eenconsulting.com.