Making Sense of (Ultra) Low Cost Flights: Vertical Differentiation in Two-Sided Markets

The business model of low cost carriers is now well-established and accounts for a large share of western civil aviation, particularly in Europe. To understand why it has proven so successful, we develop a theoretical model that exploits the two-sided nature of flights as connectors of supply and demand for goods and services other than traveling itself across physical space. Carriers offer flights of different quality and may sign agreements with suppliers of goods and services at the destination so as to subsidize and foster demand from the carriers' travelers as in standard two-sided markets. Customer-travelers care about home and destination consumption and about the flight's quality. Hence, beyond the thickness of the connected sides of the market, the quality of the airline-platform has an intrinsic value to travelers. We show that only low-income travelers fly with low cost airlines, while no-frills carriers are more likely to act as a platform than legacy airlines. We study how the degree of substitution between home and destination consumption affects the equilibrium market structure of the airline industry.