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Price Discrimination in the Airline Industry: How Airlines Maximize Revenue Through Dynamic Pricing
Booking airline flights can be stressful, as prices seem to change based on the timing of your purchase and from which website you make your purchase. Like most online activity, purchasing time-sensitive goods and services is now often influenced by algorithms that try to maximize seller revenue based on estimates of consumer demand. This may even be coming to brick-and-mortar businesses near you, at least for perishable items like fast food: restaurants are looking at dynamic pricing, also known as surge pricing, as an option.
Dynamic Pricing Explained
Dynamic means changing, and dynamic pricing means that prices can change for different consumers based on their perceived willingness to buy. Typically, prices are lower for consumers whose demand is more elastic and are more willing to walk away. For example, some restaurants offer sale prices on certain goods at non-peak times of day, which may entice additional customers. This is a more classic example of dynamic pricing, with no algorithm or model making regular adjustments to the price.
Modern dynamic pricing is seen more often with tickets and passes, which are nowadays almost entirely digital. Companies do not need to physically stock any printed documents and can change their listed prices instantly on websites and apps. They can engage in price discrimination by charging different consumers more or less money, and will charge higher prices when they think consumers are willing to pay more.
Requirements for Price Discrimination
Price discrimination requires some degree of market segregation, or the ability to separate consumers by characteristics that affect their demand. This usually requires the ability to block consumers from suitable substitutes for one’s product, at least temporarily. Airlines are well-suited to this, as there are few suitable substitutes for cross-country or international travel. If a person needs to get from New York City to Los Angeles, or from London to Rome, there are not many realistic substitutes if the timeline is short. A trip that must be made within only a few days may only be possible via airline.
Airlines may also have monopoly power over specific routes, allowing them to charge higher prices. Some international flights, for example, may only be available through one airline, creating a true monopoly. This has increased in recent years due to mergers and acquisitions, with airlines consolidating into a concentrated oligopoly in most markets. In the United States, for example, four airlines control 80 percent of the civilian air travel market. For most consumers, therefore, there is little ability to find a substitute for a high-cost airline ticket.
Price Discrimination and Revenue Maximization
The goal of price discrimination is to maximize revenue by charging each consumer the highest amount he or she is willing to tolerate. For airlines, this is easy because elasticity of demand is heavily influenced by the amount of time the customer has to make the journey. If a flight is being booked months in advance, the airline must charge a lower price because the customer can seek substitutes, such as train, boat, or automobile travel. If a flight is being booked only a few days in advance, however, the airline can charge a high price because there are no substitutes.
On a graph of a traditional free market economy, all consumers pay the market price, also known as the equilibrium price. Some consumers, however, are getting a good deal: they are [secretly] willing to pay much more for the good than they have to. These consumers receive consumer surplus, which is the difference between what the consumer is willing to pay and what he or she has to pay. Perfect price discrimination captures all consumer surplus and transfers it to the seller. Market price is eliminated.
Perfect Price Discrimination and Artificial Intelligence
For sellers, perfect price discrimination is difficult to achieve. Consumers, obviously, never want to admit that they desperately need to buy a good or service, lest they be charged a higher price. Historically, this has left sellers to estimate consumer elasticity of demand based on various scenarios, often using market research. In recent years, however, the proliferation of artificial intelligence (AI) has allowed sellers to more easily process and use massive amounts of customer data.
AI allows for much better market research by sifting, sorting, and processing tremendous volumes of data about consumers and their habits at record speed. It can incorporate additional variables, such as multiple substitute goods and their availability. With AI, airlines can do more than just raise prices by X percent each Y hours the flight draws nearer - they can adjust prices based on train ticket and rental car prices, weather conditions for using substitute transportation, or even public perception of air travel at the moment versus other modes of transportation.
Controversially, AI can remove more consumer surplus, and thus lead to higher airline profitability, than pre-AI methods of price discrimination. Depending on the amount of data an AI software has access to, it may even be able to adjust ticket prices based on the estimated income and/or net worth of the purchaser. This would increase airline profits even further, but also raise ethical questions.
Ethical Questions About Dynamic Pricing and Use of Consumer Data
While surge pricing has been common for years, especially when it comes to booking travel plans, the prices were largely independent of consumers’ personal data. With AI, however, sellers can glean highly personal data, including financial data, about prospective customers. If all airlines begin using such AI, they could all charge high-income individuals very high ticket prices and leave them with no suitable substitutes for long-distance travel. Obviously, many would consider this highly unethical.
Some economists would argue that dynamic pricing run amok, if it was allowed to access consumer financial data, would virtually eliminate workers’ drive to earn higher wages. Why work hard to become a highly paid expert, after all, if you must pay proportionally higher prices for every product? This could cause widespread decreases in societal productivity as workers decided their efforts to perform highly and receive bonuses and promotions were financially moot.
Alternatively, other economists would argue that dynamic pricing today inherently disadvantages those with lower incomes. Low-wage workers are less likely to have the free time and research ability to explore all substitutes or schedule activities and purchases to occur during non-peak hours. These workers may find their schedules always forcing them to pay surge prices, as they cannot get time off to run important errands during the work day. Lower-income individuals may also have less ability to choose where to live or how to commute, forcing them to accept high prices on essential services.
Should Governments Regulate Dynamic Pricing?
Previously, airlines were regulated. In 1978, the Airline Deregulation Act in the United States removed government price controls and allowed for freer competition among airlines. This led to lower prices initially, but this trend has reversed in recent years due to many factors, including airline consolidation. New technology allowing for rapid dynamic pricing, such as apps and websites, has raised ticket prices further for many consumers.
Many would argue that governments should prevent price gouging from firms trying to maximize profit during emergencies, when consumers are desperate. In some U.S. states, laws against price gouging exist, though none currently do at the national level. Proponents of limiting dynamic pricing to prevent price gouging argue that humanitarian factors should trump profit-seeking. They also argue that dynamic pricing can hurt markets by causing consumer distrust, leading to unrest and declines in productivity and consumption as consumers believe they are being manipulated.
Opponents of regulations on dynamic pricing argue that such price changes increase market efficiency through the rationing function of prices and can therefore prevent shortages. Without dynamic pricing, those experiencing consumer surplus may over-purchase, causing excess scarcity and blocking other consumers from the market. An example would be wealthy people buying airline tickets very frequently at a low market equilibrium price for leisure trips, preventing many others from getting seats on flights they needed for work or important travel.
