Air Line Pricing Case Study

I. INTRODUCTION“The airline industry’s pricing system is a

billion-dollar house of cards in which everycustomer is a futures speculator and Economics 101is turned onto its head” (Fredrick, 1995). Thisstatement highlights one of the most hiddenfrustrations that many air travelers feel. Airlinepricing is so distorted that often a full-fare payingpassenger is seated next to a passenger who paidmore then three hundred percent less for his or herticket. What makes this situation so exasperatingis that each passenger is receiving the same qualityof seat and in-flight service, regardless of the airfareeach paid. This paper will attempt to uncover theforces that have created this chaotic pricing systemthat has confused and annoyed passengers in today’sair travel industry.

Very few other industries have undergoneanything like the drastic changes that have rockedthe U.S. domestic airline industry in the past twentyyears. Over this time period, the industry hasevolved from a system of long established airlinesflying a regulated route structure to a dynamic, freemarket environment where new airlines emergedand disappeared seemingly overnight. Recently theindustry has become more characterized by massivemarket dominance by a small group of majorairlines. Given its past volatility, there is little doubtthat the industry will continue to transform overtime. All the while, air travelers have continued toseek an understanding of all the chaos.

The focus of this paper will be on developinga model that demonstrates the effect two specificexogenous shocks had in creating the airlineindustry’s current pricing system of vast airfaredispersion amongst passengers on the same flight.The model developed establishes that certain airlineshave used market segmentation and pricediscrimination tactics as a result of these exogenousshocks. The organization of this paper is as follows.

Section II provides historical background into theairline industry before 1979 when drastic changesbegan to occur. Section III develops a model forairline pricing on the basis of monopolisticcompetition in order to describe the determinants ofthe airfare charged for a given flight. Section IVbuilds from the model to describe the theoreticalframework that leads to the hypothesis of the use ofmarket segmentation and price discrimination in theairline industry. Section V presents historicalanalysis of the post-deregulation period in order tobetter understand the evolution of the current pricesystem. Section VI breaks the mechanisms used byairlines to segment their customers and then providesempirical evidence of the use of price discriminationon routes between Atlanta and three separate cities.Section VII finishes with concluding remarks.

II. HISTORICAL BACKGROUNDVolatility in airfares is a relatively new

phenomenon in the airline industry. Since airtravel’s creation, U.S. airlines had been subject togovernment regulation similar to that of publicutilities. In 1938, Congress passed the CivilAeronautics Act, which gave regulatory power tothe Civil Aeronautics Board (CAB) to oversee theairline industry. The main purpose of this act wasto keep sound economic conditions in the industrysince it provided for the public’s welfare. The CABhad the responsibility to regulate the following areas:market entry, rate determination, and antitrustauthority. This allowed the CAB to determine whichroutes airlines would fly and establish airfares atrates the CAB found reasonable. Additionally, theCAB sought to prevent harmful alliances betweenairlines and stop any other forms of anti-competitivebehavior between airlines (Dempsy & Gotz, 1992).

Regulation initially created a favorableenvironment and a group of established airlinesarose and became known as the trunk carriers. For

Understanding the Chaos of AirlinePricing

By Alex Kons

The Park Place Economist / vol. VIII 15

The Park Place Economist / vol. VIII16

the next 40 years, the 11 trunk carriers provided87% of the air travel needs of the United States(Bailey, Graham, and Kaplan, 1991). Over this timeperiod, the CAB consistently kept fares higher thanthe market level and severely restricted entry of newcompetition. As a result, the trunk carriers weremore than willing to exist with each other as longas they continued to make consistent profits.

Yet by the 1970’s the trunk carriers all wereoperating at record losses. The main reason for thiswas that the trunk carriers had ordered largenumbers of new jet aircraft in order to prepare forforecasted booms in passenger demand. However,the recession of the early 1970’s slowed demandfor air travel, which along with the high cost of thesenew jets created prolonged losses for the trunkcarriers. Many airline executives pushed the blameon the CAB since it was an easy scapegoat, eventhough fault really lay with the airlines themselves(Bailey, Graham, and Kaplan 1991).

While this problem persisted in the industry,opposition by lawmakers to the CAB began to formout of concern that the airline industry needed to bemore competitive. Many began to advocate thatthe CAB had failed to provide for public welfarebecause it had created a monopolistic industry withinflated airfares. Unfortunately for the CAB, ampleproof for this claim existed. For example, a groupof interstate airlines had grown to provide moreaffordable air travel on their flights. These airlineswere not subject to CAB authority as long as theyflew within only one state. The most famous ofthese interstate airlines was Southwest Airlines,which flew in Texas. Southwest competed withtrunk carriers on many routes and charged faressignificantly lower, which generated greater airtravel demand. More importantly, Southwest wasalso consistently profitable (Bailey, Graham, andKaplan, 1991).

The prolonged stagnation of establishedairlines and the demand for more affordable airtravel lead to the passing of the Airline DeregulationAct in 1979. The result of this act was completeelimination of the CAB’s authority, leaving theairline industry in a free market. Almostimmediately, a number of new airlines arose tocompete with the trunk carriers and the industry

would be changed forever (Glab and Peterson,1994).

III. DEVELOPING THE MODELTo understand the roots of chaotic pricing

in the airline industry, it is necessary to know theunique nature of competition that exists in theindustry. In order to develop the most coherentmodel for airline pricing determination, the industryis modeled in terms of monopolistic competition.This firm model applies to industries with a largenumber of firms that have some degree of productdifferentiation. Additionally, this model assumesthat there are few barriers to entry and that someamount of brand loyalty exists (Mansfield, 1997).

As a whole, the airline industry follows themonopolistic competition model quite well. Thebarriers to starting an airline are actually relativelysmall when compared to many industries. Initialstart-up costs of an airline are expensive, butsufficient financing has always been readilyavailable to fund these costs. Also, airlines oftendo not own their airplanes, favoring instead to takeadvantage of the lower initial costs of leasing aircraftfor short periods. Finally, passengers tend to developsome degree of brand loyalty towards one airline,especially when compensated for their loyalty, suchas with frequent flyer programs (O’Conner, 1995).

In this paper, airlines will be classified basedon two different strategic groups in order to analyzecompetition. The notion of two strategic groups inthe airline industry is based on Margaret Peteraf’swork, which classified an airline as belonging toeither the major airline group or the low-cost airlinegroup. These two groups have many key differencesin their competitive structure.

Large networks of flights and billions ofdollars in revenue characterize the major airlines.Low-cost airlines on the other hand fly only a limitednumber of routes and obtain far less revenue thanthe majors. Another difference between the twogroups lies in their cost structures. Major airlineshave highly unionized workforces and the mostexpensive airport facilities, while low-cost airlinesare non-unionized and always focus on cost effectivefacilities. As the name implies, low-cost airlineshold a significant cost advantage over the major

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airlines. Another important difference is that majorairlines offer more passenger amenities than theirlow-cost counterparts. This implies such items asin-flight meals, roomy seats, and frequent flyerprograms. Low-cost airlines focus solely on offeringthe most cost effective travel to their customers. Alsothe major airlines are all well established with steadyoperating histories, such as American Airlines,which has existed for 80 years. On the other handlow-cost airlines often initiate and leave markets sorapidly that they barely make long-term impacts onpassenger flows. In fact, no member of the low-cost group has even been inbusiness longer than thirtyyears (Peteraf, 1993).

To develop aneffective model for pricing,there are certain aspectsunique to the airlineindustry that will beincorporated to themonopolistic competitionmodel. First, airlinesdemonstrate the tendencyto form monopolies oroligopolies on certain routes between two cities. Itis important to note that this does not affect theassumption of low barriers to market entry in themodel because this type of monopolization does notprevent new competition in the short-run. It maybe possible for new entrants to compete on a routewith a monopolizing airline, but often new entrantsdo not survive in the long-term due to anti-competitive tactics used by established airlines.Many airlines successfully monopolize specificgeographic areas of the country by concentratingtheir flights from a large city to surrounding cities.This tactic is known as the hub and spoke system.For example, since Northwest Airlines operates overseventy percent of the total flights out of Detroit,the airline’s monopoly on many flights allows it tocharge on average a 46% premium to its passengers(http://ostpxweb.dot.gov/aviation).

The second unique aspect to consider is thatpassengers always value price of airfare and traveltime convenience over any form of productdifferentiation. The higher qualities of in-flight

amenities that the major airlines emphasize playvery minor roles in determining the airlinepassengers chose. According to William O’ Conner,“The speed, comfort, and safety aspects of thejourney are more likely to be much the same,whichever airline a passenger selects” (1995 p.5).The primary reason passengers select a particularairline is based on the cheapest airfare and the mostconvenient departure and arrival times. As a result,airlines typically will match each other’s fares oncompetitive routes, but attempt to gain morepassengers than their competitors by offering more

flights on the route. Thismaximizes the likelihoodthat passengers will get theirpreferred flight times. Topassengers this form ofdifferentiation is not easilyperceived, because it doesnot involve the comfort oftheir seat or price of theticket (O’Conner, 1995).

The final uniqueaspect of the airline industryand perhaps most important

is that the total cost for providing a flight is almostsolely determined by the airline’s fixed costs.Regardless of the flight, the two principal costs arejet fuel and the labor costs of the crew. Passengeramenities constitute most of the variable costs, butthese represent such a small portion of total coststhat they are insignificant. In other words, theaverage total cost of a given flight is almost entirelydetermined by the average fixed costs (O’Conner,1995).

Drawing on this aspect, it can be concludedthat the marginal cost of an additional passenger ona flight is irrelevant. Since total costs are almostentirely made up of fixed costs, the airline pays forthe production costs of a full flight regardless of howmany passengers are actually on a flight. Forexample, if the average total cost to seat eachpassenger remains approximately $1000, then themarginal cost of seating 50 versus 100 people onthe airplane is almost zero. However, a flight thatdeparts with empty seats represents lost revenuesince the airline has already paid the costs to provide

...low cost airlines ofteninitiate and leave marketsso rapidly that they barelymake long-term impactson passenger flows.

Understanding the Chaos of Airline PricingUnderstanding the Chaos of Airline PricingUnderstanding the Chaos of Airline PricingUnderstanding the Chaos of Airline PricingUnderstanding the Chaos of Airline Pricing


the seat (Dempsy & Goetz, 1992).Taking these factors into consideration, the

model developed to demonstrate airline faredetermination for a flight must differ from howmonopolistic competition determines price. Mostimportantly, the airline’s choice of fare cannot bedetermined through the standard monopolisticcompetition model that dictates that the intersectionsof the marginal cost and marginal revenue curvesdetermines the price the firm should charge. Thereason for this is that the marginal revenue and costcurves do not intersect in this paper’s model becauseof the assumption that the marginal costs of eachadditional passenger is insignificant for the airline.Since marginal cost and revenue serve no importantrole in this industry, they are eliminated from thismodel.

When an airline decides to offer a flightbetween two cities, it must first determine what sizedairplane to use on the route. In the model of airlineprice determination, three different-sized categoriesof airplanes are used to demonstrate this decision.In Figure 1, ATC1 and Q1 represent costs andseating capacities of 50 to 70 passengers, whichconsists of small turboprop airplanes. ATC2 andQ2 correspond cost and capacity of airplanesholding 120 to 150 passengers, such as the Boeing737. Finally, ATC3 and Q3 symbolize largerairplanes cost and seating of 200 to 260 passengers

such as the Boeing 767 or McDonnell. Note thateach ATC curve has its own distinct shape in orderto represent its specific airplane type.

This model assumes that through adequatemarket research an airline can determine demandlevel for each flight, which allows construction ofthe demand curve in Figure 2. By comparing thedemand curve with the average total cost curves foreach airplane type, the airline can determine whichsize airplane will maximize profits for a given flight.As shown in Figure 2, the airline will choose Q2 asthe airplane to operate because this airplane providesthe greatest total area of profit of the three Q levels.The airline then uses Q2 to price off the demandcurve, which establishes the appropriate single fareto charge. The model developed in this paperconcludes that the airline’s choice of Q-level leadsto the determination of the fare charged. For theremainder of this paper, Q2 will be assumed to bethe profit maximizing level of quantity.

IV. EFFECT OF SHOCKS ANDHYPOTHESIS OF MARKETSEGMENTATION AND PRICEDISCRIMINATION

Now that the model has been developed toexplain airline price determination, it will bedemonstrated how airline pricing has been shapedby two key exogenous shocks. The effect of

Figure 1: ATC Curves for Q1, Q2, & Q3

ATC 1 ATC 3

ATC 2

Fare

Q1 Q2 Q3Quantity of Seats Offered

a b

c d

e f

g h

ij

k l

Figure 2: Determining Q Level for Flight

Q1 Q2 Q3Qunatity of Seats Offered

Fare

Legend:F 1= Airfare charged for Q1 levelF 2= Airfare charged for Q2 levelF 3= Airfare charged for Q3 levelD 1= Demand Curve for individual flight



government regulation for one flight on the modelis shown in Figure 3. By setting airfares above themarket clearing level, the government prevents theairline on this route from filling all seats up to Q2.Yet, as long as competition is kept out on this flight,the demand curve is kept artificially high and theairline is content to fly with a partly full airplane atQR. The reason for this is that the airline is stillmaking a constant profit despite not filling everyseat because of the CAB keeping demand high byrestricting competition. This characterizes the long-term stability for the major airlines that existed underregulation.

This steady environment was radicallyaltered by the first exogenous shock to the model,which was the deregulation of the airline industry.The effect this has on the model is shown in Figure4. Taking away the government’s barriers to entryallowed for low-cost airlines to enter markets andcompete with the major airlines. The entry of thisnew competition shifts the demand curve from D1to D2, which causes profits for the major airlines todisappear. This demand shift caused by the entryof low-cost airliners causes the fare in this marketto decrease from FR to FD. This lower airfaremakes it impossible for the major airline to coverits average costs because of the higher nature of their

costs when compared to the low-fare airline. Yet,the low-cost airline can make a profit at this newprice level through its lower cost advantage. If itwere not for the cost advantage shown in ATCL,new competition would not have entered the marketand decreased the demand curve because airlineswould not have been able to cover their average costs .

The second major exogenous shock thataffected the airline industry’s pricing came into effectat the same time as deregulation, which was theinformation technology revolution and thedevelopment of the computer reservation system.During the 1960’s, the major airlines had workedto develop a computerized system that would allowthem to know the flight details of any passenger onany of its routes. At first, these systems were seenmore as means to boost labor productivity bymaking it easier to handle large amounts ofreservations (Williams, 1994). Yet, by the mid-1970’s, the airlines began to see that a reservationsystem had potential as a valuable tool to increasethe number of passengers. Therefore, the airlinesjoined together and attempted to create an unbiasedindustry-wide system. However, the governmentoverturned this attempt on the grounds of anti-trustviolation. As a result, the five largest airlines eachcommitted to creating their own reservation systems

Figure3: Effect ofGovernment Regulation

F 2F R

Legend:Q2- quantity offered by airlineQR- quantity filled as a result of government price settingF2- airfare as determined by market

FR- airfare as determined by government intervention

ATC 2

Fare

Quantity of Seats Offered

QR Q2

D1

Figure 4: Entry of Low-Cost Competition

Fare

Q 2Legend:D 1- demand curve that existed before Deregulation ActD 2- demand curve as a result of new competitionATC 2-average total cost curve for major airlineATC L-average total cost curve for low-cost airlineFR- previous airfare under regulationFD-airfare created by deregualtion

F D

F R

Quantity of Seats Offered

D 1

D 2

ATC L

ATC 2



at the same time the Deregulation Act was passed(Glab and Peterson, 1994).

As Figure 4 indicates, the influx of low-costairlines brought forth by deregulation created a veryunfavorable environment for the major airlines. Thelow-cost airlines could compete directly with themajor airlines on a given route, fill all seats at areduced fare, and still make a profit. The majorairlines’ attempts to leave fares at the higher pricein hopes that passengers would appreciate the higherservice level of the majors proved impracticalbecause, as discussed before, passengers value thelowest airfare over any amenity. What many of themajor airline executives were failing to recognizewas that deregulation had created an environmentwhere a major airline charging a single price on aroute would not allow profitability. This notioncombined with characteristics unique to the airlineindustry made it necessary for the major airlines tosegment their passengers on each flight accordingto each one’s willingness to pay and then use pricediscrimination methods to steal consumer surplus.This method of maximizing the price each passengerpaid for their ticket could allow the major airlinesto make profits despite the cost advantage held bythe low-cost airlines.

In order to understand this concept ofsegmenting each passenger on a flight, it must firstbe made clear that each passenger on a flight hasdifferent reasons for travel. For example, a businesstraveler often has no advance warning concerningwhen he or she will travel and has a strong necessityto get to where he or she is going as expediently aspossible. Therefore, this group of travelers has avery low price elasticity, which means they are morewilling to pay a higher airfare in order to guaranteetravel on a specific flight that would be needed fortheir travel itinerary. Contrast this type of passengerwith a vacationer who has had advance knowledgeof their vacation period and does not have a strongurge to get to their destination at any specific time.Thus, vacationers will have high price elasticity andfervently value price before convenient flight times.These two types of travelers represent the twoextremes of air travelers with various other groupshaving price elasticities somewhere in-between. Inreality, an airline continually attempts to segment

the market for one flight as much as possible if thewillingness to pay is known. Predicting this out ofso many potential travelers would be a daunting taskif it were not for the use of computer reservationsystems to provide the key to this information.Through research into a flight and effective use of areservation system, a major airline obtains the abilityto predict the willingness to pay of each passengeron the airplane.

Once the willingness to pay for eachpassenger is determined, the airline can then adjustfares according to the types of passengers purchasingtickets. This results in groups of travelers with lowerprice elasticities paying a higher airfare than thosewith higher price elasticities, which clearlyrepresents price discrimination. The form of pricediscrimination practiced here falls somewherebetween first and second-degree discrimination. Infirst-degree discrimination, the firm is specificallyaware of the price that consumers are willing to payfor the seat and thus can maximize the consumersurplus taken from their customers (Botimer, 1996).This serves as the goal of the major airlines and ispartly attained by using computer reservationsystem, yet the sheer number of potential customersfor a flight makes first-degree unobtainable. Second-degree discrimination allows the firm to take some,but not the entire consumer surplus by offering afew, well-defined pricing categories. The airlinescreate so many different classes of prices that mostconsumer surplus is taken, thus making this formof price discrimination stricter than second-degree(Botimer, 1996). The large size of potentialcustomers makes first-degree impractical, but thevast number of prices possible with computerizedreservations allow the airlines to obtain moreconsumer surplus than second-degree discriminationoffers.

Previous studies have examined the vastdispersion in airfare prices that exists for passengerson a given route. One of these aimed specifically atthis paper’s notion that a key linkage between pricedispersion and discrimination exists. The work ofBorenstein and Rose used Gini coefficients asmeasures of dispersion and revealed two keyfindings. First, they found that price dispersion wasinversely related to how much market share an



airline has on a given route. In other words, anairline is less likely to offer a range of airfares if itcarries most of the passengers on a route. This isevidence that monopolization of a route makes pricediscrimination unneeded for an airline. The secondfinding was that airport dominance and the lowerconcentrations of tourist traffic both decrease pricedispersion. Airport dominance implies an airlineoffering a significant number of flights, whichincreases thelikelihood of theairline havingmonopoly routes.Since touristsrepresent a highlyelastic passengergroup, an airline isless likely to beable to use pricediscr iminat iontactics in order todraw consumersurplus. Thisstudy’s principalconclusion agreeswith that of thispaper, which is thatmost of thedispersion inairfares is linked to price discrimination tactics usedby airlines (Borenstein and Rose, 1994).

The practice of market segmentationfollowed by successful price discrimination servedas the means for the major airlines to competesuccessfully with low-cost airlines in thederegulation era. By offering low fares, customerswho only will pay lower prices can be obtained.These fares are offset with passengers who payhigher fares, in order to allow the airline to make aprofit despite some fares being below average costs.Figure 5 demonstrates the use of this system. Fivecategories of fares are used in this case, eachdesigned to steal consumer surplus from fivedifferent groups of passengers based on theirelasticites. The environment of deregulation andthe computer reservation system created this system,which explains the origin of the price dispersion that

exists to this day.

V. ANALYSIS OF THE POST-DEREGULATION ERA

To properly understand the effect low-costairlines had in shaping competition, it is necessaryto examine the strategies of these firms in moredetail. Probably the most interesting of these airlinesto analyze is People Express which began operations

in April, 1981.The airline’splan was tofocus on highfrequency, lowcost air travelon the EastCoast, whichhad been anunderdevelopedmarket underr e g u l a t i o n .From the start,People Expressset out to keepo p e r a t i o n a lcosts at the bareminimum. Thea i r l i n econcentrated its

operations out of Newark Airport, which at the timeoffered very low facility costs and also providedconvenient access to New York City. PeopleExpress’s aircraft were leased for short time periods,thus saving on the high cost of new aircraft.Employees were all non-unionized and often workedmultiple positions, such as both flight attendant andticket agent. Additionally, passenger comforts werelimited by requiring passengers to pay for amenitiessuch as baggage check-in and in-flight beverages(Peterson and Glab 1994).

This bare minimum cost structure allowedPeople Express to charge fares significantly lowerthan the major airlines, allowing the airline to holda crucial advantage in competing with the majors.For example, when People initiated service fromNewark to Norfolk, it offered a one-way fare of $35.The only fare offered up to this point by the

Fare

F 1F 2F 3

F 4

F 5

Quantity of Seats OfferedQ2

Figure 5: Use of Segmentation to Steal ConsumerSurplus

ab

c d

Legend:area a: consumer surplus taken from passengers paying F1area b: consumer surplus taken from passengers paying F2area c: consumer surplus taken from passengers paying F3area d: consumer surplus taken from passengers paying F4



incumbent major airline US Air had been $82. Theentry of People Express forced US Air to drop itsfare to $35. Even matching fares could not helpUS Air compete and shortly after the airline ceasedflying the route and diverted its resources to routeswithout low-cost competition (Glab and Struken,1994). The situation faced by US Air on this routeprecisely follows the predictions of Figure 4. USAir simply could not cover its average costs at thelow fare that People Express was able to charge,thus causing it to stop flying from New York toNorfolk. This example typifies the reaction of mostmajor airlines to entry by low-cost airlines. It waspossible for the majors to battle the low-cost airlinesby taking short-term losses in hopes of outlastingthe low-cost competition in the long run. However,most majors instead chose to pull out or reduceservice on routes with low-cost competition. Themajors also tried ineffectively to slice their costs byretiring less efficient jets and furloughing workers,but it proved impossible to bring average costs downto the level of the low-cost airlines. Industry analystsat the time compared the majors to lumberingdinosaurs, doomed for extinction (Glab & Struken,1994).

As the problems continued for the majors,People Express and other low-cost carriers continuedto enter more routes as profits rose. In fact, by thesummer of 1984, People Express was the fastestgrowing company in American history at the time.The major airlines were finally beginning to see thatthe old system of pricing with one standard fare wasnot going to allow profitability (Glab & Struken,1994). At first, the major airlines tried tinkeringwith the old system in order to induce more revenues.For example, United Airlines ran one promotion inlate 1982 where coupons for reduced ticket priceswere given to passengers during flights. Thisrepresented a primitive attempt by United to segmenttheir passengers into frequent and new customersand price discriminate against new customers(LaCroix, 1984). As was the case with most of thesemethods created by the majors, coupons failed toremedy the profitability problems faced by United.

As the problems continued for the majorairlines, the technological revolution was creatingan explosive growth in the major airlines’ computer

reservation systems. The new competition sparkedby deregulation had brought about so many newairlines and flights that passengers could no longerrely on the airlines to determine the best fare for aflight. It is important to note that each system’sdatabase listed all possible airline flights regardlessof whether an airline owned the reservation system.This was necessary because many passengers hadto make connections between flights on two differentairlines to meet their travel needs. The number oftravel agencies using reservation systems soonturned out to be crucial in the post-deregulationenvironment. The competitive advantage thatcomputer reservation systems provided for the majorairlines soon became readily apparent (Williams,1994).

As a result of consumer demand, travelagencies soon became the consumer source forunbiased flight information. To meet the demandsof travel agencies for fast access of all availableairline information, airlines that owned computerreservation systems actively marketed their units tothe agencies. Figure 6 demonstrates the massivegrowth in travel agencies in the aftermath ofderegulation, which was accompanied by almost allagencies using computer reservation systems. Asshown, the number of travel agencies grew over150% and almost every one used a computerreservation system. The most popular systems wereAmerican’s SABRE and United’s Apollo, whichcollectively controlled over half of the total numberheld by travel agencies (Williams, 1994). Theimportance of an airline owning its own reservationsystem at this time cannot be overstated. “An in-house CRS has provided airline managers with adegree of clarity about the demand for variousofferings that one would ordinarily associate withthe hypothetical examples contained inmicroeconomic textbooks” (Williams, 1994). Thegrowth of CRS gave the major airlines themechanism, in which to know their customer’swillingness to pay, which allowed the use ofdiscriminatory pricing.

The major airline’s response to the low-costcompetition finally arrived on January 18, 1985,when American Airlines announced that one out ofevery three seats would be sold at heavily discounted



prices. The new fare called the Ultimate Super Savermatched the fares of low-cost airlines on every routewhere they competed with American. This singleact took away the vital advantage that low-costairlines had been exploiting over the majors, whichwas that they could make profits at low airfares.The key to the new Ultimate Super Saver was thatit carried a number of purchase restrictions thatprevented it from being the accessible to passengersat any given moment. By using their CRS toestimate elasticity levels, American could alter thenumber of discounted seats offered as demandchanged. Other airlines with reservation systemssoon followed American’s strategy and the systemof pricing that exists today was in-place (Glab &Struken, 1994). This system has become known asyield management, which represents nothing morethen a technical term for successful marketsegmentation followed by price discrimination.

Although no one predicted it at the time, theadoption of yield management became the primecause of the downfall of the low-cost airlines. Withyield management in place, the major airlines couldcompete with the low-cost airlines at lower prices,yet still make profits due to the revenue generatedfrom higher fares obtained from passengers whocould not obtain discount fares. As predicted in themodel, these passengers were typically businesstravelers that were more willing to pay for theconvenient schedules offered by the majors.Passenger choice almost always went with the majorairlines, because they tended to offer more flightson their routes and also offered better passenger

amenities (Glab & Struken, 1994). The results ofyield management are best demonstrated in Figure7, which shows the entry and exit of low-cost airlinesby year. Note that almost every low-fare airlinewas gone by 1986, which was only a year afterAmerican initiated its yield management system.

No other low-fare airline left in suchspectacular fashion as People Express. At the startof 1986, the airline became the sixth largest airlinein the country and even had international service toEurope. Yet, in the next two quarters People Expresslost over one hundred million dollars and soon wasbankrupt by the late spring. The principle reasonfor People Express’ dramatic collapse was due tothe loss of its customers to the low prices generatedby the majors’ yield management systems. It tooka little over a year for People Express to go from anairline with a limitless future to bankruptcy. PeopleExpress was bought out by Texas Air Corporationin January of 1987 and merged into ContinentalAirlines. Coincidently, airfares immediately beganto go up on routes that People Express had served(Dempsey & Goetz, 1992). The collapse of PeopleExpress demonstrates just how powerful the weaponof market segmentation and price discriminationwas in helping the major airlines crush their low-cost competition.

VI. APPLICATION OF MODELA. Understanding Purchase Restrictions

Thus far, historical evidence has beenprovided to describe the adoption of marketsegmentation and discriminatory pricing tactics by

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Source: Williams 16



the major airlines. It is now necessary to describethe mechanisms the major airlines have used toensure that only passengers with low willingness topay obtain discounted airfares. After all the entiregoal of yield management fails to be met ifpassengers with high willingness to pay end uppurchasing cheaper tickets. To alleviate thisproblem the major airlines developed a system ofrestrictions on discounted tickets that has preventedthis from occurring. Essentially, a fare restrictionacts as a fence to prevent passengers with higherwillingness to pay for air travel from obtaining lowerairfares and allows the airlines to steal the valuableconsumer surplus that maximizes profits on a flight.Three common restrictions that will be analyzed inthis paper are advance purchase, minimum stay, andoff-peak travel requirements. The effect of theserestrictions on passengers will be compared betweena highly price sensitive vacation traveler and a priceinsensitive business traveler.

Advance purchase requirements necessitatethat passengers buy their tickets before a given date,which can range from two weeks to a month beforethe date of their flight. To passengers flying forvacations this restriction is little trouble becausevacation time is usually known and planned out wellin advance. Yet for business passengers, these faresare almost always unattainable because completetravel itineraries are rarely known until a few daysbefore the business trip. Therefore, this restrictionensures that vacationers obtain the limited numberof discounted seats for a given flight.

Discounted airfares also often contain aminimum stay requirement for passengers. Themost common type of this restriction is thatpassengers stay through Saturday night at theirdestination before making their return flight. For avacationer this presents little trouble because theirvacation period extends typically over a weekendand Sunday is the desired day to return home.Conversely, a business traveler typically has fulfilledthe purpose of his or her trip during the week and isvery unwilling to waste their weekend away fromhome in order to save on airfare. Thus, thisrestriction serves to block business travelers fromobtaining lower fares.

The final restriction examined is the

requirement that passengers traveling on discounttickets fly on off-peak flights. Since airlinestypically offer multiple numbers of flights over thecourse of a day between two cities, some flightsgenerate greater demand than others. Flights withhigh demand typically are during the week frommidmorning until early evening, thus these flightsare in the peak-demand periods. Conversely, theoff-peak period is either early in the morning, atnight, or during the weekend. Since the demand ishigher for peak flights, the airlines strictly limit thenumber of discounted seats on these flights in orderto steal as much consumer surplus as possible. Fora vacationer, travel on off-peak flights would be seenas a small hassle if it were necessary to savesignificantly on the airfare. Yet for a businesstraveler, off-peak travel creates too much travelbecause his or her ultimate need is to theirdestination as their schedule demands, which isalmost always during peak periods. Therefore, onoff-peak flights, a significant number of seats aresold at discounted prices to provide for passengerswith a low willingness to pay.

B. Case Study: Atlanta and Delta AirlinesNow that the foundations have been laid for

understanding how the airlines effectively segmenttheir passengers, an analysis of three different routeswill demonstrate the use of price discrimination.Delta Airlines will be used as the major airline foranalysis on three separate routes that all originatein Atlanta. This choice was made because Deltaoperates one of the largest single operations inAtlanta of any airline in the world. Therefore, thisairport dominance allows Delta to hold monopolieson many flights, which results in higher airfares.By analyzing Delta’s flights from Atlanta to threedifferent cities where it faces varying levels ofcompetition, the dynamics of segmentation and pricediscrimination become readily apparent.

The first flight for analysis is from Atlantato Little Rock, where Delta is the only airlineoffering nonstop service. Figure 8 shows the variousfares offered to passengers on these flights. Deltadoes offer two discounted and two standard faresfor the route. Notice that the discounted fares bothcarry purchase restrictions requiring advance



purchase of either one or two weeks and do not allowreturn flights until Sunday. Also, neither of thediscounted fares are refundable in the case ofcancellation. The advent of the yield managementsystem has allowed for consumers to obtain somediscounted airfares even though Delta holds amonopoly on the route. The principle reason Deltastill offers discounted tickets lies in the fact thatselling them at discounted fares allows for each flightto fly as close to its maximum capacity as possible.This allows Delta to avoid the losses associated withhaving empty seats on the flights for this route.

Notice how the increase in airfares stays relativelyconsistent at around $200 as the fare classes changefrom discount to standard. Delta’s monopoly onthe flights between Atlanta and Little Rock doesnot necessitate a lot of variability in fares to adjustfor the varying levels of each passenger’s willingnessto pay.

The next route for analysis is betweenCharlotte and Atlanta, where Delta’s competitionis US Airways, which also is a major airline. Figure9 lists the fares offered on this route. The effect ofcompetition causes increased variability in prices

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Figure 8: Atlanta to Little Rock Price Analysis

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Figure 9: Atlanta to Charlotte Price Analysis



than on the Atlanta to Little Rock route. Restrictionson the discounted fares seem well placed to partitionpassengers and allow for biased pricing to succeed.Additionally, it is very likely that Delta and USAirways both strictly limit the number of seats soldat discounted fares. This allows each airline tocapture passengers with very low willingness to payand squeeze out more consumer surplus from theless flexible in their travel needs.

The final route examined is from Atlanta toBoston, which best demonstrates the practice ofmarket segmentation and price discrimination. Theprimary reason for the wide dispersion in airfaresdemonstrated in Figure 10, is that Delta competeswith the low-cost airline, Air Tran, on this route.Just as the model developed in this paper predicted,the effect of low-cost competition causes Delta tosegment and discriminatorily price againstpassengers as much as possible. When Air Tranbegan flying between these two cities, Delta had tolower fares to Air Tran’s level in order to preventlosing passengers. Therefore, Delta used theprinciples of yield management to create the route’sfare structure. There are five discounted fares onthe route, which are designed specifically to matchAir Tran’s fares. The low prices placed on thesefares allows Delta to obtain many of the highly pricesensitive passengers that would select Air Tran fortheir travel needs if each airline charged only theirstandard fare. Due to its higher costs, Delta’sstandard fare is much higher then Air Tran’s.Therefore, Delta uses five sets of discounted faresto compete with Air Tran for passengers with lowwillingness to pay. Delta knows that by properlyrestricting the fares the airline can prevent these faresfrom resulting in high levels consumer surplus.

Discount Fares One through Three appearto be targeted toward passengers traveling for thepurposes of leisure. The restrictions that allow thisto occur are the use of advance purchaserequirements and the limitations placed on what daya passenger can select to travel. For businesstravelers, the advance purchase requirements makeit especially difficult for them to obtain these lowerfares since they often do not know their travelitineraries until the day before they need to leave.Discount Fares Four and Five are designed to meet

the needs of business travelers with slight flexibilityin their travel needs. As indicated in Figure 10,these fares only carry the restriction that travelersuse early morning and evening flights, which areoff-peak times of the day. This is less of a hassle totravelers than requiring them to stay throughSaturday. The use of these discounted fares withfewer restrictions seems to indicate that Delta wantsto take as many travelers as possible from Air Tran.

The huge jump in price from the discountedto standard fares is due to the fact that on a givenflight Delta must make-up for the significant numberof discounted tickets sold by maximizing the pricethat passengers that are insensitive to increases pay.Delta is demonstrating exactly how a major airlinesteals consumer surplus from the lower elastic groupof travelers. Compare the increase in price fromthe highest discount fare to the lowest standard fareon this route to this increase on the previous tworoutes. On the Atlanta-Boston route the increase isapproximately 300%. However, on the previoustwo routes, the increase from discount to standardis only about 40%.

Passengers paying the standard fare areobtaining benefits by paying these higher fares, suchas the ability to receive refunds for travel and,perhaps most importantly, the flexibility to travelon any one of Delta’s flights between Atlanta andBoston. By providing more flights than Air Tranbetween the two cities, Delta is able to obtain moretime-sensitive passengers who are willing to pay apremium in order to get to where they need to go.Delta’s tactics of yield management in this marketallow the airline to fend off competition from AirTran and still make profits by stealing consumersurplus from price insensitive passengers.

VII. CONCLUDING REMARKSAirline pricing was drastically changed by

the influx of low-cost airlines brought byderegulation and the creation of computerreservation systems. The revolutionary concept ofvaried pricing according to demand is one of thesole reasons that the major airlines were able to fendoff the low-cost airlines and increase theirdominance of the nation’s air transportation needs.Deregulation has made air travel affordable for a



much larger portion of the population.The prime purpose of this paper was to serve

as an overview of the events that lead to the creationof the pricing system used in air travel today.Although airfares seem to change so chaotically, thesystem itself can be seen quite simply as evolvingfrom the major airlines need to segment eachcustomer based on their willingness to pay for travel.Once this is determined from computer reservationsystems, the airline simply follows through bydiscriminatorily pricing to steal consumer surplus.Understanding how the airlines develop their pricestructure can allow for passengers to obtain lowairfares.

A key policy implication that this papermakes apparent is that businesses should seekalternative methods to conduct transactions ratherthan through using air travel. Essentially findingalternatives to air travel will causes airlines to loseout on their most critical customers for producing

revenue. As the information technology revolutioncontinues, it may become more conceivable forbusiness to be conducted through teleconferencingrather than in-person. As a result, the airlines willhave to stop discriminating against business travelersin order to keep them flying. This will signify amajor change in the strategy that airlines use to price.Other technological advances such as the growth ofinternet travel bookings signify that the airlines mustupgrade their pricing methods into the 21st century.Nevertheless, market segmentation and pricediscrimination tactics have played a significant rolein assuring the continued dominance of majorairlines.

REFERENCESBailey, Elizabeth, Graham, David, and Kaplan,

David. Deregulating the Airlines.MIT Press: Cambridge, 1991.

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Figure 10: Atlanta to Boston Price Analysis



Dempsey, Paul and Goetz, Andrew. AirlineDeregulation and Laissez-Faire Mythology.Quorum: Westport, 1992.

Glab, James and Peterson, Barbara. RapidDescent. Simon & Schuster: New York,1994.

Mansfield, Edwin. Microeconomics. W.W.Norton: New York, 1997.

Morrison, Steven and Winston, Clifford. TheEvolution of the Airline Industry. BrookingsInstitute: Washington DC, 1995.

O’Conner, William. An Introduction to AirlineEconomics. Praeger: Westport, 1995.

Williams, George. The Airline Industry and theImpact of Deregulation. Ashgate: Brookfield,1994.

Borenstein, Severin and Rose, Nancy. “Competi-tion and Price Dispersion in the U.S. AirlineIndustry.” Journal of Political Economy 102.4(1994): 653-683.

Botimer, Theodore. “Efficiency Considerations inAirline Pricing and Yield Management.”Transportation Research 30.4 (1996): 307-315.

Fredrick, Benjamin. “Understanding AirlinePricing.” Working Woman 20.4 (1995): 31-34.

LaCroix, Sumner. “Airline Coupons and PricingAdjustments.” Journal of TransportEconomics and Policy 18.3 (1984): 253-262.

Peteraf, Margaret. “Intra-Industry Structure andthe Response towards Rivals.”Managerial and Decision Economics 14.6(1993): 519-528.

Department of Transportation. “The Low CostAirline Service Revolution.” Online.Internet. September 20 1999. Available URL:http://ostpxweb.dot.gov/aviation

Yahoo Travel. Yahoo! November 11 1999.Available URL: http://www.yahoo.com


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