The pricing economics of the airline industry

Introduction:

Since its deregulation and liberalization, the airline industry has become more concentrated and one of the most competitive industry in the present world. The most distinctive aspect about the industry today is the high level of variations in the prices charged with respect to factors like dates, time, class etc, the differential pricing strategy adopted and the way airlines actually use them to drive home competitive advantage. This report aims to show the Price discrimination that occurs in the Airline industry.

Airline Pricing:

Pricing is continually viewed as one of the most critical part of any business; pricing, in a way, makes or breaks a business. In this era of high technology penetration, and increased competition, the emphasis laid on charging the right customers with the right price has become increasingly high. This is pretty obvious since pricing helps companies enhance and capitalize on competitive advantage (Stern, 1989). Airline industry is signified by a concentrated market and heavy competition between the players; it is also the one defined by huge fixed and operating costs. To add on to the above, the product that is sold is also perishable; hence in order to ensure and sustain profits in the competitive environment having a very efficient pricing strategy is a must. Also in this present age of increasing differences in the way the customers perceive a product offering and the differences in the levels of buying powers of the consumers, succeeding in the industry using the traditional ‘set the prices at the marginal costs’ will generally not recoup sufficient revenue to cover the large fixed costs and sunk costs involved within the industry (Varian, 1996). The above is the clinching point behind the need for price discrimination and price dispersion across the industry. To achieve an efficient means of doing this, the airlines use a mixture of Yield Management, Rationing and Price discrimination by carefully segmenting its customer base using the principle of price elasticity of demand. (Kambli,2002)

Price Elasticity of Demand and Price Discrimination:

Price elasticity of demand is defined as a “measure of the responsiveness of quantity demanded to a change in price” (Sloman and Hinde, 2007). It is the foundation on which the entire pricing system of the airline industry is based upon. For designing an efficient and an effective pricing strategy of a business, knowing the price elasticity of demand of the market inside out becomes mandatory for all the industries. Price elasticity of demand for a good is directly related to the possibilities of substitution for that good (Brons, 2002). A relatively large number of substitutes will imply high price elasticity whereas the lack of it will force the demand to become inelastic.

In economic terms, capturing the market’s consumer surplus is the major purpose of price discrimination. This surplus, in a market with a single clearing price, arises mainly because; some customers (the very low price elasticity segment) would have been prepared to pay more than the single market price. Price discrimination transfers some of this surplus to the producer/marketer from the consumer.

It can be proved mathematically, that a firm facing a downward sloping demand curve that is convex to the origin will always obtain higher revenues under price discrimination than under a single price strategy. This is shown diagrammatically below.

Figure 1 : Sales Revenue without and with Price Discrimination

Source :Economics, John Sloman

In the diagram above, a single price (P) is available to all customers. The area P, A, Q, O represents the amount of revenue. The area above line segment P,A but below the demand curve (D) is the consumer surplus.

With price discrimination, (second diagram in Figure 1), the demand curve is divided into two segments (D1 and D2). (P1) is the higher price charged to the low elasticity segment, and (P2) is the lower price charged to the high elasticity segment. The area P1,B,Q1,O is equal to the total revenue from the first segment. The area E,C,Q2,Q1 is equal to the total revenue from the second segment. Assuming the demand curve resembles a rectangular hyperbola with unitary elasticity, the sum of these areas will always be greater than the area without discrimination. The more prices, that are introduced, the greater the sum of the revenue areas, and the more of the consumer surplus is captured by the producer.

Note that the above requires both first and second degree price discrimination: the right side segment corresponds partly to different people than the left segment, partly to the same people, willing to buy more if the product is cheaper.

It is very useful for the price discriminator to determine the optimum prices in each market segment. This is done in Figure 2 where each segment is considered as a separate market with its own demand curve. The Profit maximizing output (Qt) is determined by the intersection of the marginal cost curve (MC) with the marginal revenue curve for the total market (MRt). (Sloman, 2000)

Figure 2 : Profit Maximising output under Third degree Price Discrimination

Source :Economics, John Sloman

The firm decides what amount of the total output to sell in each market. This is determined from the marginal revenue curves in each market. The intersection of the marginal revenue with the total market price curves in each market yields optimum outputs of Qa and Qb. The profit maximizing prices of Pa and Pb can be determined from the demand curve in each market.

Multiple Market Price Determination:

Airline industry is one in which both elastic and inelastic demand patterns co-exist and it is the reason why the core tickets are cheaper compared with the add-ons like Taxes, charge for extra baggage’s etc. A business passenger with the least price sensitivity, high time dependence, who books the tickets days or hours before the flight is a perfect example for the inelasticity in the market. The surplus earned or generated by the airline from this inelasticity actually balances the diminishing revenues and discounts suffered in serving the elastic leisure travellers with a high sensitivity on price and relatively elastic schedules there by helping the firms to sustain its profitability. Similarly, another principle which helps the industry in sustaining its profits is the segmentation of the market, into price sensitive and the non price sensitive segments and having a segment based pricing strategy – Third Degree price discrimination. Airline industry segments their markets according to class of travellers, like Luxury or first, Business Class and economy class, purpose of travel, like business or leisure etc and also on the amount of demand for a particular root. Using these segmentations helps them to efficiently get an insight into the consumers’ willingness to pay and maximize the extraction of consumer surplus from each one of them. (Martijn, 2002)

Yield Management:

Yield management, also known as revenue management, is a process of understanding, anticipating and influencing consumer behaviour in order to maximize revenue or profits from a fixed, perishable resource. Since the airline industry satisfies the three main basic necessities i.e. fixed and perishable resources and the differences in the customers willingness to pay, yield management is one of the most extensively used concept in the industry. It also leads to an efficient way of operation and forms the basis for the price discrimination decisions taken by the firm. With regards to yield management, airlines attempt to segment the demand in the market by offering different combinations of price levels and restriction bundles or fare products designed to appear differently to consumers with different levels of willingness to pay (Botimer, 1999). Based on the level of willingness to pay airlines impose restrictions (fences) on the lower fares to prevent other segment consumers from buying tickets at a discount. Seat allocations according to the above are achieved by the usage of complex yield management systems which uses a nested asset control mechanism to carry out the same. Another source of fare differentiation is Rationing. Segmentation and rationing exploit the difference in the willingness of the customer to pay through different channels at different times with different levels of effort. (Kambli, 2001). In other words rationing can be explained as the phenomena where the supply at the lower price is limited and distributed among the customers. With rationing the airlines use fares to allocate their supply of limited seats among consumers. This is how airlines manage the seemingly difficult price variations and resource allocations efficiently and effectively and remain competitive in the industry.

Equilibrium Point:

This is the point where the organisation has no loss or gain. Airlines can work out through the demand and supply curves and can identify the break-even point where the organisation suffers no loss, nor does it have any gain. After assessing this value, Airlines can decide how many

Figure 3 : Equilibrium price curve

Source : Earl and Wakeley, 2005

seats could be allotted under concessional price and how many could can be sold under the business class category. Say, the break-even point is at 50% of the entire tickets, where Airlines can run without making a loss even if the rest of the tickets are not sold. In this case, Airlines can decide to sell a small percentage of the 50% at a discounted price. The remaining % of the tickets could be left for selling under the business class category. This would give a good margin of profit for the organisation. (Earl and Wakeley, 2005)

Complications and Extensions:

The Implication of Yield management system has a wide variety of complications. Some of the implications we face are discussed below :

Demand Forecasting:

When implementing a yield management system we always use historical demand to predict future demand. In an actual application, we may use more elaborate models to generate demand forecasts that take into account a variety of predictable events, such as the day of the week, seasonality, and special events such as holidays. Another natural problem that arises during demand forecasting is censored data, i.e., company often does not record demand from customers who were denied a reservation.

Variation and Mobility of Capacity:

Assuming that all units of capacity are same is one of the major drawbacks of the yield management systems.

Customers in a Fare Class are not all alike:

A business traveler on an airplane flight may book a ticket on just one leg or may be continuing on multiple legs. Not selling a ticket to the latter passenger means that revenue from all flight legs will be lost.

In each of these cases, the total revenue generated by the customer should be incorporated into the yield management calculation, not just the revenue generated by a single flight leg. There are additional complications when code-sharing partners (distinct air lines that offer connecting flights among one another) operate these flight legs. If code-sharing occurs, then each of the partners must have an incentive to take into consideration the other partners’ revenue streams.

Winners and Losers in Price Discrimination:

Yield Management in the Airline industry aims at maximizing profit. But this process makes customers either winners or losers. Consider a case where the Economy class seats are filled up, with much seats available in Business class. So when a passenger trying to book a Economy class ticket, will be given a seat in the Business class, but will be charged with the Economy class fare. This makes that particular passenger, ‘A Winner’. Those other passengers traveling in the Business class become ‘Losers’, since they travel with a high fare than that particular passenger.

Figure 4 : Winners and Losers from Price Discrimination

Source : Lecture Notes

Conclusion:

Sustained profitability, occupies the top spot in any industry’s vision statement. It is the one, which drives companies in search of new techniques and methods to ensure they end up on the green, year on year. The above combined with industry’s urge to succeed in the highly competitive environment and effort to package their offerings in an attractive way to the consumers’, forms the key solution for the ever eluding puzzle of variations in airline pricing.