Dynamic Pricing in the Airline Industry

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Dynamic Pricing in the Airline Industry
R. Preston McAfee and Vera te Velde California Institute of Technology

Abstract: Dynamic price discrimination adjusts prices based on the option value of future sales, which varies with time and units available. This paper surveys the theoretical literature on dynamic price discrimination, and confronts the theories with new data from airline pricing behavior.

Correspondence to: R. Preston McAfee, 100 Baxter Hall, California Institute of Technology, Pasadena, CA 91125, preston@mcafee.cc.

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Computerized reservation systems were developed in the 1950s to keep track of airline seat booking and fare information. Initially these were internal systems, but were soon made available to travel agents. Deregulation of airline pricing in 1978 permitted much more extensive use of the systems for economic activity, especially pricing. The initial development of dynamically adjusted pricing is often credited to American Airlines’ Robert Crandall, as a response to the rise of discount airline People’s Express in the early 1980s. The complexity and opaqueness of airline pricing has grown over time. As a result, the “yield management” systems employed by airlines for pricing have become one of the most arcane and complex information systems on the planet, and one with a very large economic component. Airline pricing represents a great challenge for modern economic analysis because it is so distant from the “law of one price” level of analysis. This paper surveys the theoretical literature, which is mostly found in operations research journals, develops some new theory, assesses the holes in our knowledge, and describes some results from a new database of airline prices. Dynamic pricing, which is also known as yield management or revenue management, is a set of pricing strategies aimed at increasing profits. The techniques are most useful when two product characteristics co-exist. First, the product expires at a point in time, like hotel rooms, airline flights, generated electricity, or time-dated (“sell before”) products. Second, capacity is fixed well in advance and can be augmented only at a relatively high marginal cost. These characteristics create the potential for very large swings in the opportunity cost of sale, because the opportunity cost of sale is a potential foregone subsequent sale. The value of a unit in a shortage situation is the highest value of an unserved customer. Forecasting this value given current sales and available capacity represents dynamic pricing. Yield management techniques are reportedly quite valuable. One estimate suggests that American Airlines made an extra $500 million per year based on its yield management techniques (Davis 1994). This number may be inflated for several reasons. First, it includes sales of yield management strategy to others, as opposed to American’s own use of the techniques, although the value of American’s internal use is put at just slightly less. Second, it incorporates “damaged good” considerations in the form of Saturday-night stayover restrictions, as well dynamic pricing. Such restrictions facilitate static price discrimination, and are reasonably well-understood in other contexts (Deneckere and McAfee 1996). Nevertheless, there is little doubt that dynamic price discrimination is economically important. The pricing systems used by most major airlines are remarkably opaque to the consumer, which is not surprising given one estimate that American Airlines changes half a million prices per day. The implied frequency of price changes seems especially large given that American carries around 50,000 passengers per day. There is surprisingly little research in economics journals concerning yield management, given its prominence in pricing in significant industries and the economic importance attached to it. This paper contributes to our understanding of yield management in five ways. First, it provides an extensive survey of yield...
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