Price Discrimination in the Airline Industry: A Study of Dynamic Pricing Strategies

How often have you checked an airline’s website, looking to find the best seat prices, only to face eye-watering prices for the day you want to travel? This is particularly the case the closer you are to your departure date. The main reason for this is that airlines use price discrimination and dynamic pricing to ensure they attain the most revenue from their flights.

Airlines Set Their Prices Using Yield Management.

Any time you book a seat on a flight you will typically find a range of fares available. Apart from obvious differentials, such as comfort (First Class vs. Business Class vs. Economy) and the amount of luggage you can take with you, prices will differ based on the time and date of a flight, and how full a flight is at the time of booking.

Before the mid-1980s, there was heavy regulation of airlines in many countries. This changed, with the arrival of governments pursuing a more Monetarist philosophy than previously, like Reagan in the USA and Thatcher in the UK. The first route to face deregulation was between the UK and Ireland in 1986. This saw reductions in fares of more than 50%. Over the next decade, countries deregulated many more air routes, and new budget airlines arrived on the scene, ready to take on the more established names of air travel.

American Airlines can lay claim to be the first airline to introduce yield management. Its then-president, Robert Crandell, claimed that the airline generated an extra $500 million a year, using such practices as charging cheaper rates to early payers, charging extra for a seat reservation, and overbooking, although the last of these practices was frowned on by many.

Airlines have continued variations of yield management for the last 40 years, to generate the highest revenue from its passengers, whilst at the same time trying to avoid alienating them too much.

Airlines face high fixed costs – it costs a considerable sum for them to place a plane in the air. However, their variable costs are low – once they commit to a flight, it costs very little to add an extra passenger, until the flight is fully booked. Therefore, the cost of the first ticket to sell on a flight is very high, but the marginal and average costs reduces greatly with each extra seat sold.

A good yield management system maximises revenue (yield) for the airline, by modifying prices to best meet different types of demand for airplane seats. Ideally (for the airline), they will be able to sell the maximum number of seats, each at the highest price that someone is willing to pay.

Static Pricing vs. Dynamic Pricing

Airlines have traditionally used static pricing. Here, they set a relatively small number of price points, each designed for specific customer segments and price points. For example, the prices they charge potential passengers may depend on a few factors like time of flight, days until departure, number of stopovers, level of service required, and sales channel chosen. An airline groups customers into segments based on these factors and then sets a series of price points. When somebody searches for a ticket, the airline prices each available seat, based on which segment the seat best suits.

While static pricing worked capably with airline yield management over the years, the airlines now can produce better results using dynamic pricing. Here, they can use analytics to extract many more data factors and adapt their prices accordingly.

With dynamic pricing, an airline constantly changes and adjusts the offered seat prices based on the demand for each seat. The word ‘dynamic’ means constantly changing, and potential flyers are likely to see quoted prices for a seat change nearly every time they go to an airline’s website.

We have previously written about dynamic pricing, and find that most airlines manage to meet the four necessary conditions for the practice to work:

•  Businesses have some degree of market power or the ability to change the price – wherever airlines are minimally regulated, and there are relatively few airlines servicing each route, the airlines have control over the ticket process they set.
• There are different types of customers in the market with different price elasticities of demand – the airlines have focused on building these segments and adapting their pricing accordingly.
• Businesses have continuous access to the data about the changing demand for their products – with modern technology and analytics, most airlines now have excellent access to data.
• Businesses can prevent the re-selling of the product between customer groups – the airlines have built up websites making it easy for people to buy their tickets. In addition, the airlines have made it difficult for people to re-sell tickets (needing ID for flyers for security purposes and ensuring that they have an exact manifesto of who is on each flight).

Price Discrimination in International Airline Markets

In 2021, Gaurab Aryal, Charles Murry, and Jonathan W. Williams wrote a paper for the University of North Carolina, where they examined Price Discrimination in International Airline Markets. They used unique data from international airline markets with flight-level variation in prices across time, cabins, and markets, as well as information on passengers’ reasons for travel and time of purchase.

The researchers found that the ability to screen passengers across cabins every period increases total surplus by 35% relative to choosing only one price per period, i.e. the airlines generated a 35% surplus by offering different pricing/service tiers. However, they found that further discrimination based on a passenger’s reason for travelling improved airline surplus at the expense of total efficiency. Their study discovered that current pricing practice yielded approximately 89% of the first-best welfare, and the remaining inefficiency was mainly due to dynamic uncertainty about demand, not private information about passenger valuations.

How Does Elasticity Affect Airline Pricing?

Diana Wawrzonkiewicz recently researched Assessing the Relationship Between Airline Elasticities and Price Setting. She found that each ticket is marketed according to its elasticity, i.e. how price-sensitive it is. The level of elasticity differs depending on whether a flight is marketed towards business or leisure travel. Leisure travel (vacation, personal gratification etc.) is elastic – when prices rise consumers dramatically reduce their leisure travel.  Business markets, however, are inelastic – a price change only makes a small change in the demand for the service, most businesspeople make their flights anyway.

Wawrzonkiewicz found that leisure market ticket prices have an average elasticity of 1.89, and business markets have an average elasticity of 0.375. As a result, airlines price up seats on flights they know attract mainly businesspeople. This is also one of the reasons why the airlines increase prices nearer to departure day. People tend to book leisure travel well in advance, while businesses are more likely to book flights with little notice.