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Price And Market: Analysis Of Airlines Pricing Strategy

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Question:

Discuss about the Price and Market for Analysis of Airlines Pricing Strategy.

 

Answer:

Introduction 

Airlines have always practiced charging different prices from different customers. In the huge world of aviation history, this phenomenon of different prices exists for every airline, small or big. The airlines charge different prices for the tickets based on flying class, extra services such as meal cost, luggage cost, time of ticket sales, time of flying, season, privilege membership etc. This is termed as price discrimination in economics. The practice of selling the same product or service at different prices to different consumers for maximizing revenue and profit is known as price discrimination (Baumol and Blinder 2015). The sellers act as a monopolist or oligopolists and determine the price through price discrimination. In the airlines industry, the price of the tickets fluctuates over the period of sales. It rises rapidly when the departure date approaches. It is a very important phenomenon because an individual pays a price for the seat, which might be significantly different from the person sitting next to him. This practice helps the airlines to maximize profits multiple times than what they would have made otherwise. This phenomenon is also known as price differentiation or intertemporal price discrimination. This occurs when heterogeneous customers take entry into the market at different point of time, this creates incentives and opportunities for the airlines to discriminate the price and maximize profits (Moulin 2014). The following report focuses on economic analysis of the pricing strategy by the airlines.

Price Discrimination

Various Aspects of the Exchange Process

Price discrimination is a very common practice in the business world. Firms apply this practice to get different prices from different customers. This is a pricing strategy that enables the firms to charge differentiated prices for the same good or service. Under pure price differentiation, the firms charge the maximum price to each consumer, which he is willing to pay. In the common practice, it is seen that firms make segmentations of the consumers based on different attributes and make separate target groups and charge different prices to different customer groups (Varian 2014). When the profit from separate markets is greater than the profit from the combined market, the firms go for price discrimination. The relative demand elasticities of the markets determine the level of price discrimination. In a relatively inelastic market, the price is charged at a higher rate and in the relatively elastic market, price is charged at a lower rate (Baumol and Blinder 2015).

Price Discrimination 

Figure 1: Price Discrimination

(Source: Varian 2014)

There are three types of price discrimination, namely, first degree, second degree and third degree. First degree discrimination arises when a firm charges the maximum price for each unit that a consumer is willing to pay. This process captures the entire consumer surplus for the firm. The second degree occurs when the firms charge different price for different quantities of a product or service consumed. For example, when a firm gives discount on bulk purchases, then second degree discrimination is practiced. In third degree, a company applies price discrimination to different customer groups (Nicholson and Snyder 2014).

In case of airlines, the industry has the market with different customer segments. From high value business customers to lower income class and holiday tourists, the airlines have one of the most diverse and segmented markets. The third degree discrimination is most common in this industry. The airline companies make different segments of market based on income, needs, tastes and preferences, and prices accordingly (Chandra and Lederman 2015). The airline companies and different groups of customers are the agents in this system. An airline charges higher price for a particular flight, whose demand is high. Similarly, people prefer to travel on weekends; hence, the weekend flights are more expensive than weekday flights. Price differentiation occurs in the economy and business class tickets, for additional services such as, meals on board, extra leg room, blankets, books, magazines, headphones, luggage, booking time, flying schedule, on and off season, choice of destination etc. Hence, the airlines charges price for convenience. The business class tickets are way too costly than the economy class tickets, but the comfort is much more in the business class, with special services such as extra leg room, complementary meals, extra luggage allowance etc. Again, the flight, which departs at midnight is priced lower than the one that departs in a convenient time in the day. Time of purchase is also crucial in this industry. As the departure date closes in, the price rises considerably. Lower price comes with certain disadvantages such as non transferable and non refundable tickets, no extra luggage allowance, no complementary meals etc. (Escobari and Jindapon 2014).

The equilibrium outcome is achieved when the combined profit is maximized. The airlines use techniques, like, Expected Marginal Seat Revenue (EMSR) for optimizing the fare. This system depends on choice and distance of destination, revenue generating opportunities across the network. When the difference between the cost of flying, that is, fuel cost and operating cost and the revenue earned is maximized, equilibrium is reached and fare is decided for different groups of customers (Lazarev 2013).

Factors Affecting market Outcomes Over Time

There are many factors that can affect the market outcome over time. Firstly, the customer profiling made by the airlines help to set the prices. The airlines can make reasonable assumptions on the profile of passenger traffic on a route and set the prices accordingly. For example, the price for a holiday destination is different from that for a business destination. Similarly, when the airlines assume that tourists generally book for an early morning flight, and months before the holidays, then they are tempted to raise the price high for the seats on the holiday destination routes and would adjust later based on the market demand. On a business route, the airlines start with lower fare to fill up a minimum capacity and then start raising the prices. Majority of the companies have introduced privilege services for high value passengers such as frequent flier miles and extra add on services, like transferable tickets, extra leg room, meals, gifts, discounts etc. (Dai, Liu and Serfes 2014).

Secondly, the cost reduction is another major factor that could affect the market outcome. In a competitive industry, fuel efficiency and reduction of total cost can give advantage to the airline companies. This can result in decline in the ticket prices and increase in popularity. Through technological improvement, market integration, and market competition, the companies can develop profit maximizing strategies and fuel efficiency (Marshall 2015).

Thirdly, the regulatory policies by the governments affect the market prices for the airlines. In a free market environment, the companies can determine their own pricing as per the competitive advantage to reach their goals in short and long term. However, if the government starts to regulate the prices to reduce the market exploitation, then the impact of price discrimination would be reduced (Chandra and Lederman 2015).

Welfare Implications of the Exchange Outcome and Scope for Public Policy Intervention (efficiency vs equity)

The exchange outcomes include the operating cost reduction, fuel efficiency and government regulatory policies. With the technological improvement, the airlines can reduce its cost of operations. It also helps in achieving fuel efficiency. This would result in fall in the ticket prices, which would be beneficial for the customers. In this context, the concept of efficiency and equity can be illustrated. Efficiency refers to optimal production and allocation of the given resources with the existing factors of production. On the other hand, equity refers to the way the distribution of resources occurs throughout the entire society. In the airlines industry, efficiency can be achieved in many ways, through quality of product, quality of services and effective pricing (Czerny and Zhang 2014). Technological development can make the flights fuel efficient and increase the level of comfort with the flight. These are preferred by majority of travellers. However, the airlines want to reap off the entire consumer surplus; hence, their revenue is increased at the cost of consumer surplus. There is a scope of welfare in this system, as people can afford comfort by paying a certain cost (Friedman 2017).

When the demand functions in several different markets are obtained from the distributions of the reservation prices, with a difference only in averages, there exists certain conditions, which leads to higher output and higher welfare in case of third degree price discrimination in the airlines industry (Cowan 2016). According to Varian (2014), welfare is reduced under price discrimination when the production is not increasing compared to the production under uniform pricing. However, the airlines charge price according to the affordability of the public and offer the services accordingly. This increases welfare.

On the other hand, the exchange outcome explains that equity is not achieved. The distribution of resources throughout the society is not equal and the welfare is not generated by it. The airlines distribute the services for all kinds of sections within the society. However, they offer different services for different passenger groups at different prices. Hence, people afford the tickets and services as per their income status. Thus, equity is not achieved through price discrimination (Marshall 2015).

The governmental policies work as the public policy intervention in the airlines industry. It should put a price cap on the pricing. After the deregulation of airlines happened in 1978, the airline companies started to make profits by charging different prices from different customers, although the fares became cheap and affordable. The practice is still going on. However, the combined profits of the industry are going down and customer satisfaction level is also going down (Moreno-Izquierdo, Ramón-Rodríguez and Ribes 2015). Due to deregulation, fares were reduced, along with that, the volatile fuel price, international competition with less labour cost, led to welfare generation for the consumers. However, to achieve equity, price discrimination should be reduced, but since, the airlines need to make profits, regulation by the government should be limited to safety (Borenstein, S. and Rose 2014).

Conclusion

It is a very old practice by the airlines of the world to charge different price for the same product to different groups of consumers. It is a profit maximizing strategy by the airlines. It makes segments of the customers on the basis of income and tastes and preferences. The customers pay different prices for the same services. The airlines make a trade off between ‘high price more convenience’ and ‘low price less convenience’ system. The business and economy class have different type of services, such as extra baggage allowance, complementary meals and alcohol, extra leg space etc. Based on the timing of ticket purchase, time of flying, the ticket prices differ. However, through price discrimination, the airlines achieve cost reduction and efficiency, but equity is not achieved. It can be concluded that through government intervention, price cap can be imposed on the business class tickets, but that would not be profitable for the airline companies. The government can impose regulations on safety standard, but price discrimination would continue to be practiced by the airlines industry.

 

References

Baumol, W.J. and Blinder, A.S., 2015. Microeconomics: Principles and policy. Cengage Learning.

Borenstein, S. and Rose, N.L., 2014. How airline markets work… or do they? Regulatory reform in the airline industry. In Economic Regulation and Its Reform: What Have We Learned? (pp. 63-135). University of Chicago Press.

Chandra, A. and Lederman, M., 2015. Revisiting the relationship between competition and price discrimination in the airline industry.

Cowan, S., 2016. Welfare?increasing third?degree price discrimination. The RAND Journal of Economics, 47(2), pp.326-340.

Czerny, A.I. and Zhang, A., 2014. Airport congestion pricing when airlines price discriminate. Transportation Research Part B: Methodological, 65, pp.77-89.

Dai, M., Liu, Q. and Serfes, K., 2014. Is the effect of competition on price dispersion nonmonotonic? evidence from the us airline industry. Review of Economics and Statistics, 96(1), pp.161-170.

Escobari, D. and Jindapon, P., 2014. Price discrimination through refund contracts in airlines. International Journal of Industrial Organization, 34, pp.1-8.

Friedman, L.S., 2017. The microeconomics of public policy analysis. Princeton University Press.

Lazarev, J., 2013. The welfare effects of intertemporal price discrimination: an empirical analysis of airline pricing in US monopoly markets. Unpublished manuscript.

Marshall, G., 2015. Hassle costs and price discrimination: An empirical welfare analysis. American Economic Journal: Applied Economics, 7(3), pp.123-146.

Moreno-Izquierdo, L., Ramón-Rodríguez, A. and Ribes, J.P., 2015. The impact of the internet on the pricing strategies of the European low cost airlines. European Journal of Operational Research, 246(2), pp.651-660.

Moulin, H., 2014. Cooperative microeconomics: a game-theoretic introduction. Princeton University Press.

Nicholson, W. and Snyder, C.M., 2014. Intermediate microeconomics and its application. Cengage Learning.

Varian, H.R., 2014. Intermediate Microeconomics: A Modern Approach: Ninth International Student Edition. WW Norton & Company.

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