Understanding the Chaos of Airline Pricing
By Alex Kons
I. INTRODUCTION “The airline industry’s pricing system is a billion-dollar house of cards in which every customer is a futures speculator and Economics 101 is turned onto its head” (Fredrick, 1995). This statement highlights one of the most hidden frustrations that many air travelers feel. Airline pricing is so distorted that often a full-fare paying passenger is seated next to a passenger who paid more then three hundred percent less for his or her ticket. What makes this situation so exasperating is that each passenger is receiving the same quality of seat and in-flight service, regardless of the airfare each paid. This paper will attempt to uncover the forces that have created this chaotic pricing system that has confused and annoyed passengers in today’s air travel industry. Very few other industries have undergone anything like the drastic changes that have rocked the U.S. domestic airline industry in the past twenty years. Over this time period, the industry has evolved from a system of long established airlines flying a regulated route structure to a dynamic, free market environment where new airlines emerged and disappeared seemingly overnight. Recently the industry has become more characterized by massive market dominance by a small group of major airlines. Given its past volatility, there is little doubt that the industry will continue to transform over time. All the while, air travelers have continued to seek an understanding of all the chaos. The focus of this paper will be on developing a model that demonstrates the effect two specific exogenous shocks had in creating the airline industry’s current pricing system of vast airfare dispersion amongst passengers on the same flight. The model developed establishes that certain airlines have used market segmentation and price discrimination tactics as a result of these exogenous shocks. The organization of this paper is as follows. Section II provides historical background into the airline industry before 1979 when drastic changes began to occur. Section III develops a model for airline pricing on the basis of monopolistic competition in order to describe the determinants of the airfare charged for a given flight. Section IV builds from the model to describe the theoretical framework that leads to the hypothesis of the use of market segmentation and price discrimination in the airline industry. Section V presents historical analysis of the post-deregulation period in order to better understand the evolution of the current price system. Section VI breaks the mechanisms used by airlines to segment their customers and then provides empirical evidence of the use of price discrimination on routes between Atlanta and three separate cities. Section VII finishes with concluding remarks. II. HISTORICAL BACKGROUND Volatility in airfares is a relatively new phenomenon in the airline industry. Since air travel’s creation, U.S. airlines had been subject to government regulation similar to that of public utilities. In 1938, Congress passed the Civil Aeronautics Act, which gave regulatory power to the Civil Aeronautics Board (CAB) to oversee the airline industry. The main purpose of this act was to keep sound economic conditions in the industry since it provided for the public’s welfare. The CAB had the responsibility to regulate the following areas: market entry, rate determination, and antitrust authority. This allowed the CAB to determine which routes airlines would fly and establish airfares at rates the CAB found reasonable. Additionally, the CAB sought to prevent harmful alliances between airlines and stop any other forms of anti-competitive behavior between airlines (Dempsy & Gotz, 1992). Regulation initially created a favorable environment and a group of established airlines arose and became known as the trunk carriers. For
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References: Bailey, Elizabeth, Graham, David, and Kaplan, David. Deregulating the Airlines. MIT Press: Cambridge, 1991.
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