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REVENUE

MANAGEMENT

OMPETITIVE WWeapon
EAPON IN in
THEthe
AaCCompetitive
AIRLINE
BUSINESS
Airline
Business

By: Sergio Mendoza, PhD

Revenue Management,
a Competitive Weapon in the Airline Business
Airnguru, October 2016

God doesnt play dice with the universe - Albert Einstein


What would we do, as revenue management practitioners(1)
, if we had a crystal ball? We would
probably like to answer questions like:
1.
2.
3.
4.
5.
6.

How much demand will we have for our premium product next weekend?
How much would demand change if we increase or decrease the prices by 10%?
What is our customers willingness to pay going to be for coach cabin in the afternoon
flight?

What will be our main competitors reaction to a 20% price reduction in this market?
How will the exchange rate fluctuate over the next month in this market in Asia?
etc

This guide provides a simple-to-read overview of the fundamental concepts, analytics and processes
that revenue management practitioners should engage in to provide value to their airlines.
With almost 14 years of previous experience in revenue management and pricing strategies in the
airline industry, Sergio Mendoza is cofounder and CEO at Airnguru, a cutting edge pricing intelligence
technology provider for airlines. He participated in the PODS-MIT Revenue Management Research
Consortium for 10 years and formed high performance teams in a diversity of core airline business
functions, leading transformational projects and innovation with high impact on profitability.
(1)

When we say revenue management analysts or revenue management practitioners we implicitly include pricing
analysts and practitioners. Pricing is a core part of revenue management.

I. INTRODUCTION
Uncertainty:

demand is a stochastic process.


Knowing the future demand, the consumer reactions to future price changes, the future evolution of
exchange rates, etc, are among the wildest dreams of revenue management and pricing
practitioners, because anticipated knowledge of some of these future variables would allow them to
make perfect decisions in the present and succeed at their goals of maximizing airline revenues. But,
its just dreaming, normal people cant know the future; revenue management practitioners learned
to work with guesses, smart estimates or -professionally stated- forecasts.
The future is fundamentally stochastic, a result of underlying microscopic natural phenomena which
are essentially random, thanks to quantum mechanics. God actually plays dice! So, the bad news is

or customer behaviour exactly, there will always be a prediction
that we cannot predict demand

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error associated to forecasting. We may just analyze and predict demand probabilistically, within
certain confidence levels.
This is the first big challenge for revenue management and pricing analysts (and a permanent
frustration for commercial leaders).
Estimating the future demand involves a series of complex tasks. It requires segmenting the demand,
making reasonable hypothesis or estimates about exogenous variables (like the behaviour of
exchange rates, GDP, fluctuations of competitors supply, weather, special events, seasons, holidays,
competitors supply, prices and promotion, etc), incorporating and making assumptions about
parameters controlled by ourselves (like own supply, own prices, own promotion, etc), modelling of
the relationship between demand and all these variables and adjusting or training these models with
enough historical data for an adequate calibration.

The good news is that within the limitations imposed by its stochastic nature, the future can be, and
actually is, affected by our present decisions. In fact, we attempt to predict the future in order to
change that future, that is, in order to make decisions that will bend that future towards a more
convenient future.
Combinatorial complexity: demand is highly granular
On top of uncertainty, revenue management practitioners face the challenge of a big combinatorial
problem: multiple dimensions of deep granularity each, combining to produce millions of variables
for which we could take daily relevant decisions. For example, if we want to forecast the demand or
set the availability on a daily basis for each demand segment, for each future departure, for each
origin-destination, at each point of sale level, in an airline with 400 daily departures, published up to
365 days in advance, with two relevant origin-destinations per flight, two relevant markets (POS) per
origin-destination and two demand segments per market, we would need to compute around 1
million daily forecasts and make around 1 million daily availability decisions!
Thats why, in the airline business at least, the revenue management opportunity cannot be tackled
efficiently without the help of powerful technology.
What is Revenue Management?
Revenue management is a core business discipline that aims at maximizing the short term expected
profitability of assets, modelling and forecasting demand and optimizing prices and product
availability.
Revenue management integrates several fields or disciplines from economics and engineering,
including microeconomics, operations research (OR) and statistics and, in industries with high
transactional volumes (like the airline) it is enabled by the use of information technology.
In brick & mortar retail the assets are the stores (typically measured in surface units) and the
inventory (actually, the financial investment in inventory). In hospitality the assets are represented
by the rooms (or beds). In telco the asset is the bandwidth. In shipping the assets are the ships
capacities (measured in TEUs), etc.

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In the passenger airline business the assets are the airplanes that will fly a given itinerary, and
revenue management in this case aims at maximizing short term expected net revenues (which in
turn is equivalent to maximizing the expected profitability of the fleet that will fly a given itinerary).
The use of the term expected reflects the stochastic nature of the demand being modelled. It also
sets some expectations over the limitations of the revenue management discipline.

II. THE REVENUE MANAGEMENT PROCESS


The effective practice of revenue management is sustained on a robust and systematic business
process to continuously execute some critical tasks, among which we highlight:
1.
2.
3.
4.
5.

Loading system databases


Optimizing prices
Forecasting demand
Optimizing availability
Diagnosing and adjusting parameters, decisions and strategies

Note that airlines split the maximization of net revenues in two separate sub-optimizations:
optimization of prices (or pricing practice, step 2 in the diagram) and optimization of availability
(step 4). Thats how the airline industry typically works: it first defines a finite number of fare
products with their price levels and associated fare fences in order to optimally segment the demand
and then it optimizes the inventory (or seat availability) associated to each fare product and price
level. The advanced reader will note that this doesnt necessarily produce the mathematical
optimum of expected net revenues, however, this has proven to be a good heuristic to simplify an
overly complex optimization problem, given the technical, commercial, legal and sometimes political

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constraints that revenue management practitioners find when executing these optimization
processes.
Over 50% of the potential benefits of revenue management in the airline come from the
optimization of prices, ie the optimization of fare fences and price levels. In a segmented market (ie
a market that is used to the practice of fare products and fare fences) the benefits associated to
these components may represent from 15 to 20 percent points of net revenue, which is huge (in an
industry with such small margins). So, the quality of the airlines pricing practice determines whether
the airline makes or loses money. However, this is the most difficult and least systematized
component of revenue management.
The second most important contribution of revenue management comes from the optimization of
capacity or inventory allocation, ie determining how many seats to allocate to each fare product and
price level. The potential benefit of inventory allocation optimization may represent between 4 and 8
percent points of net revenues in a segmented market. The potential benefit could go above these
figures in low cost, un-fenced markets, but only partially compensating the detriment of unfencing
the market (ref: simulations of PODS-MIT). The optimization of capacity on a given fare structure is a
highly systematized component of revenue management: this, along with forecasting and
overbooking, are the core of what currently available revenue management systems do under the
supervision of revenue management analysts.
The third important contribution comes from forecasting. Simulations show that each 10 percent
points improvement in demand forecast quality may improve net revenue by 1 percent point (ref:
simulations and thesis of PODS-MIT). Again, given the small margins of the airline business, even this
extra 1 percent point contribution is huge and welcome. Forecasting is typically an integral
component of existing revenue management systems and it is a necessary input to the capacity
optimization component. Given the dynamics of the markets and the limitations of the currently
available systems (especially in the amount and diversity of data that they can handle), the
forecasting function of the system requires a lot of expert supervision. Our experience shows that
the effort of improving the forecast quality by the first 10 to 15 percent points is typically worth;
however, attempting to go further may be a much bigger effort so it should not be a priority for
revenue management teams given their high opportunity costs.
We highly recommend to keep the forecasting quality index as one of the permanent KPIs of the
revenue management process in order to control how healthy the system is running. However, not
only is it tricky to forecast, but also it is to correctly measure the forecast accuracy. Among other
complications, forecasts may suffer from self fulfilling prophecies: if you (erroneously or on
purpose) inhibit supply by keeping a fare product unavailable for a long time, the system has no way
to guess that there exists potential demand for that fare product; similarly, if demand in higher prices
is being diluted because of weak fare fencing in lower prices, the system will never experience the
real demand potential in higher prices and as a consequence it will not be able to correctly forecast
that demand. Currently available forecasting models cannot correctly forecast behaviours that they
havent seen in history, unless the users manually recalibrate them to do so. This produces high
supervision costs from revenue management teams. We expect that next generation of forecasters,
based on machine learning, may be able to automatically introduce controlled biases outside the

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boundaries of historic data in order to discover unseen behaviours and recalibrate the forecasts
accordingly.
Another relevant contribution of revenue management to the bottom line of the business comes
from overbooking. Overbooking is a way to compensate for booking or ticket cancellations that
otherwise produce empty seats. It is typically an integral component of currently available revenue
management systems. When load factors are high, overbooking may produce between one and two
percent points of extra net revenue to the bottom line of the business. There is an important
trade-off to the practice of overbooking: denied boardings. An overbooking policy requires a good
denied boarding policy, in order to minimize involuntary denied boardings and maintain the
overbooking policy effective without damaging the customer experience. Some countries prohibit
overbooking, some others have installed high penalties to airlines for denied boardings (which makes
overbooking less profitable), and some airlines have voluntarily decided not to overbook (typically
airlines with booking-less systems and with strict non-refund policies).
In low fare markets, where airlines have opted not to segment demand via fare fences, typically the
RASK (revenue per available seat kilometer, the metric for revenue generation efficiency) is
substantially lower than the one achieved in segmented markets with similar price levels. In low fare
markets there are fewer degrees of freedom for revenue management, so optimization is mainly
focused on capacity allocation.
The following graph summarizes estimates of the potential benefits of the different components of
revenue management on net revenues. These estimates (which may have a wide range, depending
on the particular airlines network configuration, load factors, percent of connecting traffic, market
position, etc) are based on simulations, on observed real cases and on the experience of the author.
More than 50% of the benefits of revenue management in the passenger airline business come from
segmentation via differential pricing and fare fences. On the other hand, availability optimization
may increase net revenues by 4 to 8 percent. Note that these figures are quite interdependent: for
instance, the impact of availability optimization substantially changes when fare fences are
eliminated. The estimate of the impact of reactive pricing here (1-3%) is the only estimate not based
on real observed or simulated data, however, we believe the figure is on the conservative side: we
assume that the airline establishes, documents, maintains and executes a consistent and systematic
reactive pricing policy; on the other hand, we know that the impact of a lousy reactive pricing
process may be disastrous in the short term and strategically detrimental in the long term.

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III. PRICE OPTIMIZATION


Introduction
In controlled markets, ie those markets or industries where prices for products and services arent a
free decision of the companies that sell those products or services, price levels are defined by the
authorities typically in order to protect consumers or to protect guilds and unions. Unless very well
informed economic criteria are used, prices defined by governments will introduce and maintain
severe distortions in the market:
(a) when the authorities objective is setting price caps to protect consumers, then they will
typically produce scarcity and black markets, because artificial price caps reduce or eliminate
suppliers margins, preventing producers from investing in capacity growth (capacity growth
would produce zero or negative returns on investment), at least while no innovation is
introduced that substantially changes the cost base; moreover, if the prices are fixed for long
times, they will make the products and services growingly attractive for consumers, because
inflation and economic growth reduce their relative price; in turn, growing amounts of
potential demand will be unfulfilled, growing scarcity will be suffered and black markets
incentivized; all these impacts get multiplied in high inflation contexts (the cases of Maduros
era in Venezuela and Kirchners era in Argentina clearly exemplify this phenomenon across
industries);

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(b) when authorities objective is setting price floors to protect guilds or unions (for example,
the price restrictions on the domestic airline industry in Argentina under the Kirchners,
whose purpose was to protect bus guilds that competed against airlines in inter-regional
passenger transportation), they restrain potential demand due to elasticity effects, they
restrain producers from stimulating demand via price and promotion, they inhibit the
introduction of low price business models and they inhibit the incentives for innovation.
This was the case of the airline industry until the late 70s in the United States. Airlines had grown
fat with full service, high single prices per market (one price per origin-destination) and loyal
customers. After the market was deregulated by the authorities in 1978, a significant growth in
capacity, demand and competition occurred, highly benefiting consumers and the economy. Revenue
management was born in the early 80s in the airline industry as a response from legacy airlines
(initiated by American Airlines) to the entrance of new competitors offering low fares for simple
service.
Pricing schemes & strategies
Deregulated markets have created pricing schemes and strategies with various levels of
sophistication. Among the various existing pricing paradigms, we highlight the following:
(a) Single price model in a steady state free market. This model is obsolete and sub-optimal.
On one hand, it does not reach all the market potential because it restrains price sensitive
customers whose willingness to pay is below the actual single price; on the other hand, the
single price model does not take advantage of consumer surplus because those customers
willing to pay a price above the actual single price keep the surplus for themselves.
Notwithstanding the above, if your business brings a disruptive technology or business model
advantage into an industry, you may reach the market with a single, easy to communicate,
very low price and succeed at gaining a big market share in a very short time, thus building
strong entry barriers before that industry becomes a steady state competitive industry again.
(b) In steady state markets, demand based (or willingness-to-pay based) differential pricing
offers a powerful way to sustain margins through demand and supply segmentation, using
fare fences and estimates of willingness-to pay (WTP) in order to stimulate demand and
obtain the consumer surplus for the supplier. Demand based pricing is the approach most
airlines attempt to use when doing revenue management. It is a tricky art & science to
determine WTP with precision, let alone its dynamic and multivariate nature. Given the high
churn rates of the airline demand due to large cross elasticities, WTP is affected by
competitors prices, so even market leaders should systematically monitor their competitors
price movements and consider reactive pricing policies to maintain their prices at optimum
levels.
(c) Value based pricing or also known as branding, will be key for longer term success of a
differential pricing paradigm. In this scheme, you elaborate a set of products or services, each
with a certain set of attributes that are easy to communicate and valued by the consumer,
and a price level. This paradigm will be necessary to fight against commoditization and to
make differential pricing sustainable and acceptable by consumers in a mature market. This
pricing scheme requires the use of sophisticated techniques, like conjoint analysis, in order to
consistently set the price levels across the set of products or services.

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(d) Through unbundling the supplier allows the consumer to purchase an extra service, gadget
or attribute that improves the base product or service that she/he is buying, for a marginal
extra cost. Unbundling generates some additional revenue for the supplier and a better
experience for the consumer. Usually these unbundled gadgets belong to more expensive
products/services upwards the value based ladder. Full unbundling allows consumers to
customize the product/service to their very specific needs, process known as
self-segmentation. As in the case of branding, consistently setting the price for an isolated
attribute (ie to avoid dilution or arbitrage) should be solved using a robust methodology like
a conjoint analysis.
(e) Suppliers use promotional pricing when they need to stimulate or accelerate demand and
get market awareness. Promotional pricing is a combination of price discount and publicity. If
advertising is not sufficiently intense the expected price elasticity of the demand will not be
fully perceived and the price discount will be dilutive (that is, the same consumers that would
have otherwise purchased for the normal price, will now be purchasing for a discounted
price).
(f) Price strategies described in b), c), d) and e) are typical examples of proactive pricing, where
the supplier proactively decides, optimizes and publishes its prices. In these cases the
supplier is typically a leader in the market, and other market participants are followers. In
opposition to this, in a market pricing scheme, the supplier is a follower, because it sets its
prices relative to its main competitors prices or relative to the market leader. In a market
pricing scheme the supplier will undercut or equal its competitors prices. This strategy is
justified when the suppliers product/service is inferior to its main competitors, when its
supply is limited though its product is comparable or when the market is of low relevance for
the supplier. Reactive pricing policies should be set by the supplier in order to be consistent
and systematic about its relative price positioning.
(g) Markup pricing is typical of industries with high marginal costs (for example, Retail). In this
case prices are set multiplying the marginal cost by a markup (a number larger than 1). This is
not the case of the airline industry. In the airline business the fleet (lease or depreciation
cost) and itineraries are fixed costs for the purposes of revenue management and the cost of
selling to and carrying an additional passenger is negligible compared to the fixed costs
(marginal costs typically represent in the order of 10% of total airline costs).
(h) Price based costs were pioneered by Intel (expressed in the famous Moores law). Ryanair is
the best example of a price based cost strategy in the airline industry. This strategy sets
frequent and aggressive price reduction goals that force the organization to implement cost
reduction initiatives, thus incentivizing continuous innovation to keep the business
sustainable.

Demand Segmentation, the first step towards price optimization


Price optimization starts with the analysis and understanding of the underlying granular structure of
the demand. Demand is originated from a wide diversity of customers with a wide diversity of needs
and preferences. In the airline business we start by distinguishing among several macro demand
segments.

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To segment demand we need to perform the necessary analysis in order to identify variables that
help us group together customer instances with similar willingness-to-pay. These variables may be
associated with purchase and consumption behavior, like booking and/or ticket anticipation,
travelling period, point of sale, purchase channel, form of payment, etc. Segmentation has to be
performed for each origin-destination market. For example, the following table summarizes some
convenient demand segmentation variables identified for the three first segments of the chart
above:

Segmentation of supply via fare fences


Once segmentation of demand is achieved, segmentation of supply is built applying restrictions on
the segmentation variables. These restrictions will reflect the boundaries of the purchase and
consumption behavior of the various types of customer instances identified in the demand
segmentation process.

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In turn, each demand segment is offered an ad-hoc fare product built using fare fences. Fare
fences -or restrictions- like advanced purchase and length of stay (also called travelling period)
applied to the purchase and consumption behavior of ethnic and tourist fare products, reduce
revenue dilution from business customers which otherwise would buy the cheapest fare product
available. Prices for different demand segments are grouped or mapped into fare classes or
RBDs, represented by a single letter of the alphabet. Each RBD then is fenced using a set of fare
fences or restrictions that appeal to a given demand segment or group of demand segments with
similar WTP, but represent a strong inhibitor to demand segments with higher WTP, as can be seen
in the following example:

Business passengers that do not want to stay a Saturday night will buy RBDs Y or B. The classical
revenue management system protects seats for Y and B but maintains RBDs M and Q available
with a limited inventory (booking limit), without diluting revenue in higher price RBDs.
An underlying assumption in classic airline revenue management is that the demand segments get
perfectly separated in fare classes or RBDs, that is, fare fences function perfectly so that fare classes
contain independent demand.
Setting the optimal price levels
Lets assume we are dealing with a specific demand segment for which we have defined a product or
service. Lets also assume that we are market leaders. A market leader should not only be proactive
at defining the product or service offer, it should also optimize price levels (instead of just following
competitors). How are optimum prices set? Microeconomics works with hypothetical demand
curves, mathematical expressions (or functions) that relate the demands of products or services
(the dependent variables) to their prices (the independent variables). In reality demand curves are
unknown and, if they exist, they should be estimated or modeled from observed data. Observation
shows that demand for a suppliers specific product or service may depend on many more variables
than just the price of that specific product/service: it depends on prices of substitute
products/services (including potential substitute products/services offered by the same supplier), on
prices of complementary products/services (for example, a lower price of hotels in a given city could
increase demand for leisure air tickets to that city), time of the day, day of the week, day of the
month, month, season, special events, weather, GDP growth, exchange rates, advertising, available
stock (obviously no stock implies no demand but limited non zero stock may also have an inhibiting
impact on demand), etc.

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Lets discuss how the theory could be applied to some very simple (and thus likely unrealistic, thats
the tradeoff) cases, in order to exemplify the use of microeconomics and statistics concepts in
revenue management:

Case 1: the simplest case


Assumptions: (a) demand dependent only on price of product/service offered, (b)
unlimited inventory, (c) two observations available and (d) zero marginal cost
Lets assume that we have unlimited inventory, that is whatever the price we set there will
always be stock (or seats) available.
Lets also assume that demand just depends on the price. Sadly, the simplest case isnt very
real: it is quite unlikely that demand depends just on the price, but, in some cases it may be a
good enough first approximation. In fact, if we are able to isolate the main independent
variables, for instance day of week and season, and just work with a constant value for
those, lets say Tuesday and high, we may be good enough just modeling demand for
Tuesdays of high season. Despite these efforts of isolating independent variables that explain
demand, we will always be left with a residual random fluctuation in the observed demand,
which is essential to its stochastic nature. So the demand curve really relates price with
expected demand, ceteris paribus.
Lets also assume that marginal cost is zero, so that optimal price is the price that maximizes
revenues (since net revenue and revenue are the same in this case).
This implies that demand (per unit time) doesnt change when price doesnt change. How
would we optimize the price of this product? Lets assume we have historical demand
observations with just two different prices (if we had always one price there would be no
way to estimate the demand curve, so, in this case, we better test changing the price and
measuring the new demand rate): at some point we had a price P1 which produced an
average demand per unit time of D1 and later we had a price P2 which produced an average
demand per unit time of D2 (at this point it is important to note that despite the assumptions
of our model, observed historical demand always behaves like a random variable, so we take
averages over several observed instances of D1 and D2).
With no more information available
the simplest assumption is setting the (expected) demand curve as a linear function of price:
D = D1 + (P P 1)

where

(D2 D1)
(P 2 P 1)

(III.2)

is the slope of the demand curve, which is related to the arc elasticity:
=

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P 1 D2D1
D1 ( P 2P 1 )

(III.1)

P1
D1

The arc elasticity of the demand to the price measured from point 1 represents the %
variation of the demand relative to D1 over the % variation of the price relative to P1.
Note that in this model and are negative constants, given the demand is linear with price
and given that it should decrease when price increases. If this were not the case when fitting
the observed data, it would mean that the assumptions of this simplified model would not be
true and the model would not be adequate (a typical case of inconsistency of our
assumptions is that of constrained inventory -to be discussed below-, where we may see
changes in prices with little or no impact on observed demand).
So, the optimum price P* is the price that maximizes revenue R (= PD):
P * = arg max R = P D

(III.3)

Replacing D for the demand function (III.1) and solving for the stationary point:
(P D)/P = 0
D + P *D/P = 0
D + P * = 0
2P * + D1 P 1 = 0

we obtain the price that maximizes revenue:


P * = 12(P 1 1D1) = 12P 1(1 1)

(III.4)

An arc elasticity at P1 of -1 will yield an optimum price P* = P1 ; an arc elasticity above -1 will
yield an optimum price above P1 and an arc elasticity below -1 (ie the demand is elastic) will
yield an optimum price below P1 (ie when demand is elastic it is convenient to reduce the
price in order to increase resulting revenue).
Replacing in III.1 we obtain the demand at the optimum price:
D* = 12(D1 P 1) = 12D1(1 )

(III.5)

So the maximum attainable revenue is:


1 (D P )2 = 1 P D ( 1)2
R* = 4
1
1
4 1 1

(III.6)

(note that a negative guarantees optimality).

Case 2: marginal cost different from zero


When there is a marginal cost c of serving one additional customer (which is most of the
times the case, at least in the airline business) the function to be maximized is not the
revenue R = PD, but the net revenue RN = (P-c)D, also called margin 1. The marginal cost c in

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the airline business covers marginal distribution costs, on-board marginal service costs,
marginal fuel cost (that is, the fuel cost of transporting one additional passenger and
luggage), etc; it may typically represents between 5% and 15% of the average price. Taking
into account the marginal cost, the optimum price may be expressed as:
P * = arg max RN = (P c)D

(III.7)

and solving for the stationary point of the right hand side term (using the same demand
curve III.1 ):
[(P c)D]/P = 0
D + (P * c)D/P = 0
D + (P * c) = 0
2P * + D1 (P 1 + c) = 0

So, the price that maximizes the net revenue is:


P * = 12( P 1 1D1) + 12c = 12P 1(1 1 ) + 12c

(III.8)

A marginal cost of c increases the optimum price by c/2 relative to the optimum price of a
zero marginal cost scenario (in a linear demand function with unlimited inventory). It may be
counterintuitive that the adjustment in price necessary to compensate for marginal cost is
not the whole marginal cost; the explanation for this lies on the fact that the demand curve
has elasticity, so any increment in price will translate into a decrease in demand, affecting the
total revenue collected. One important lesson we get from this exercise is that fuel cost
increments in the airline business should not be wholly transferred into price increments (a
pricing practice typically performed by airlines via fuel surcharges), otherwise the airline
would deviate from the maximum net revenue potential by excessively inhibiting demand.
An arc elasticity at P1 of -1 will yield an optimum price of P 1 + 12c ; an arc elasticity above -1

will yield an optimum price above P 1 + 12c and vice-versa.


The demand at the optimum price is:

D* = 12(D1 P 1) + 12c = 12D1(1 ) +

1 D1 c
2P1

(III.9)

so, the maximum attainable net revenue is:


1 (D P + c )2 =
RN * = 4
1
1

P 1D1
c 2
4 ( 1 P 1 )

(III.10)

and the revenue at the optimum price is:


1 (D P )2 + 1 c 2 = 1 P D ( 1)2 ( c )2
R(P *) = 4
1
1
4 1 1
P
4
1

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(III.11)

which is smaller than the maximum revenue (obtained in III.6). In other words, we have to
sacrifice revenue in order to maximize net revenue. Just out of curiosity lets calculate, using
III.4 and III.5, the net revenue RN = (P-c)D resulting at the price that maximizes the revenue:
RN (P = arg max R) = [12(P 1 1D1) c]12(D1 P 1)
1 (D P )2 c (D P )
= 4
1
1
1
1
2

1 (D P + c )2 + 1 c2
= 4
1
1
4

and, using (III.10) for the first term on the right we find that the net revenue at the price that
maximizes the revenue is:
RN (P = arg max R) = RN * + 14c2 = RN * +

1 D1 c2
4P1

(III.12)

That is, the net revenue at the price that maximizes the revenue is smaller than the
maximum net revenue by 14c2 . So, another important lesson here is that in the case of non
zero marginal cost, if we optimized revenue instead of net revenue we would be diluting
D
potential margin at a rate of 14c2 = 14 P 1 c2 . How large could this dilution be? Lets
1

assume elasticities of long haul leisure air travel demand to be around -3 (typical leisure
demand elasticity), prices around 1.000 US$, demand at a rate of 200 passengers per day and
marginal cost at around 100 US$ per passenger, then dilution of potential margin would be
2
200
around 14 * 1000
* 3 * 100 US$/day = 1.500 US$/day .

Case 3: constrained inventory

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When airlines practice revenue management they constrain the inventory (setting booking
limits) in order to optimize revenue, as we are going to discuss later, so it is most likely the
case that historical demand observations for a given (fare) product are constrained or
truncated via booking limits (advanced purchase -AP- restrictions have a similar effect on
demand, but we consider APs to be fixed and part of the definition of the fare product).
Thus, given the stochastic behaviour of the demand, those demand observations that would
otherwise be greater than the booking limit (BL) produce a value equal to BL, and as a

consequence, the resulting mean observed demand D will be lower than the unconstrained
expected demand D. For example, assuming that the demand distributes Poisson with mean
D, the mean observed demand will be given by:

BL1

D = eD

k=0

Dk
k!

k + eD

k=BL

Dk
k!

BL = D eD

k=BL

Dk
k!

(k BL) < D

(III.13)

This inequality suggests us that in order to optimize prices in the constrained demand case
we have no choice but to take into account the stochastic nature of the demand and, as a
consequence, de-truncate the observed demand data first, otherwise we will be
underestimating the real demand.
A side note on the choice of Poisson distribution: the booking curves slope (ie the
rate at which bookings for a specific flight get created or confirmed) for a future flight
instance varies over time till departure, but, it may be regarded as a collection of
booking rates that remain constant during certain intervals of time. Given this
observation and disregarding group bookings (since they arrive in bulk), the booking
count of each of these time intervals could be modelled as a Poisson random
variable, so, the total demand resulting from the evolution of the booking curve till
departure date would distributes as the sum of independent Poisson variables, which
is also a Poisson variable.
Looking at observed historical demand for several instances of the same fare product we may
find several types of behavior associated to the same stochastic process: (1) Non constrained
demand, i.e. demand which was freely expressed, it never hit the inventory limit of the RBD
(or booking limit BL) associated to the fare product being optimized and even the AP did not
affect the evolution of the booking curve; (2) demand is not constrained by booking limit but
it is constrained by the AP (evidenced by the booking curve reaching the AP with a positive
slope) and (3) demand was effectively constrained by the booking limit.

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How do we de-truncate the observed historical demand?


One way to de-truncate the observed demand -which is necessary to unveil the real demandwould be to measure the % of type (3) cases (that accumulate at the Peak B in Fig.5), which,
assuming a Poisson distribution of mean D and a reasonable number of historical
observations, should be given by:
BL1

% of type (3) cases P rob {Demand BL} = 1 P rob {Demand < BL} = 1 eD

k=0

Dk
k!

From this expression we can fit the mean D of the unconstrained demand.
Another, maybe simpler de-truncation method is finding the peak of the observed demand
distribution below the booking limit (ie Peak A in Fig.5 above), as long as it exists, and
relate that to D. Using discrete calculus to compute the maximum of a Poisson distribution
k
of mean D, that is, the maximum of the discrete function P (D, k) = eD Dk! (where k takes
integer values equal or greater than zero), we get two conditions for the optimum value of k,
k* :
P (D, k*) > P (D, k* 1) and P (D, k* + 1) P (D, k*)
Dk1 D
(k1)! ( k

1) > 0 and

Dk ( D
k! k+1

1) 0

which implies that


D (k*, k* + 1]

(III.14)

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That is, the mean demand D (which doesnt have to be an integer number) lies between the
booking count that maximizes the Poisson function and that number plus 1. So, in this
method D could be fit by setting
D k* + 12

(III.15)

These simple de-truncation methods fail when the % of type (3) cases is too high (because
the uncertainty of the estimator gets too high), when the Peak A is non-existent (i.e. when k*
falls above BL) or when the curve has two or more peaks below BL (in which case another
proxy could be proposed for D).
If the Peak A lies above BL it means that the demand is highly constrained. In this case we
have space for safely increasing price generating extra net revenue, since the expected
observed demand will not diminish noticeably. We could keep increasing price until we reach
a reasonably low % of type (3) data or until Peak A appears below BL, to de-truncate the
observed demand. As in cases 1 and 2, we need at least two price vs de-truncated demand
points in order to fit a linear demand curve D = D(P) and later proceed to optimize price.
If we succeeded in estimating the de-truncated demand function D, in order to now compute
the optimum price, ie the price that will maximize the expected net revenue when inventory
is constrained, we shall first rewrite the optimization function (III.7) in stochastic form:

P * = arg max < RN > = (P c)D

= (P c)( D eD

k=BL

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Dk
k!

(k BL) )

(III.16)

Solving III.16 implies solving for P the following equation (we use III.1 to relate D and P):

D = 0
< RN > = D + (P c)D

with

D D

= 1 g(D, BL)

and

g(D, BL) eD Dk!


BL

D1 (P 1 c)

So,
BL1

D
(BL + 2D)g + (2 eD(BL1)!
)D = 0

(III.17)

which can be solved numerically for D, and from D* we obtain P * = 1(D* D1) + P 1

Reactive Pricing
A robust reactive pricing process improves airlines competitive position because it makes its reactive
pricing policies more consistent, it increases its efficiency and reduces pricing errors and time to
market, generating in the long term an extra contribution to the bottom line. Some basic rules to
follow in order to maintain an adequate reactive pricing include:
1. Assure competitivity of bottom fares
Fare Levels

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Fare Restrictions
In all distribution channels
In availability of inventory

Competitivity of the bottom fare not necessarily means maintaining exactly the same price
level as the relevant competitor or the market leader, but a consistent difference, based on
the difference in value. Sometimes leading players dont let followers undercut their bottom
prices, even if the followers product is worse, so whenever the follower undercuts them
they timely react always matching the price, which could trigger a price war in the market.
2. Maintain the reactive pricing policies and the price match rules
Keep them updated
Keep them consistent
3. Monitor the competition
4. Minimize Time-To-Market
Long reactive pricing time-to-market encourages competitors to make aggressive
proactive moves, leading to market share and revenue losses

Proactive Pricing
An effective proactive pricing process ensures a good revenue share in the market (even above QSI),
enhancing profitability. Some basic rules for a robust reactive pricing process include:
1. Definition of desired price competitive position.
2. Definition of balanced price differences between fare products.
3. Definition of f are fences that effectively segment the demand, but taking into account the
competitive situation and the desired competitive position.
4. Implementation of promotional activities that stimulate demand in depressed markets or
low load factor flights.
5. Periodic review of price mapping to RBDs, price levels and fare restrictions to always ensure
a good revenue generation.
It is convenient to classify the different origin-destination markets and routes of the airline for the
purpose of defining the right pricing strategies, for which we could use the following dimensions:
1) Leisure vs business market
Typically a market with less than 40% business traffic may be classified as a leisure market and
vice-versa.

2) Load factor
A route (or a group of route flights) with an average load factor of 80% or more is a high load
factor route (or group of route flights).

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A route (or a group of route flights) with an average load factor of 70% or less is a low load factor
route (or group of route flights).
3) Dominance
If the airline is the carrier with the highest market share (MS) in a market, then the airline is the
dominant carrier in that market.
4) Industry evolution
Markets that are growing in size vs markets that are decreasing in size.
5) Low Fare vs Full Service markets
Markets with dominant airlines that use Low Fare models vs markets where dominant airlines use
Full Service models.
6) Haul
Markets could also be classified by haul (long haul, mid haul and short haul markets) so that some
fare rule templates (especially for secondary fare rules) may be defined and applied efficiently in
each scenario.

IV. FORECASTING, THE BASIS FOR INVENTORY OPTIMIZATION


Forecasts have two fundamental objectives in the airline commercial processes:
1. Determine the optimum stock/availability
Usually business customers buy very late, just a few days before departure, so, for example,
if we knew with some certainty that 5 business passengers will buy 3 days before departure,
wouldnt we keep those or some of those seats protected for them from being sold to leisure
customers who buy much earlier but are willing to pay much less?
2. Prepare for future performance
When the airline systematically forecasts expected demand, fares, margins, etc, with enough
anticipation, it will be able to make better commercial and strategic decisions that will
improve the expected performance and increase expected profitability.
Using as much of the available relevant information as possible, forecasts play critical roles in the
decision making processes. They should be an essential part of weekly route performance reviews.
Thanks to forecasts, managers and executives can drive the business looking through the
windshield, as opposed to looking through the rear-view mirror. The business should forecast the
future in order to change that future, in order to make now the right decisions that will bend that
future into the desired future.
Forecast quality is an issue, but up to a certain point. A 10% improvement of demand forecast errors
induces a 1% increase in net revenues (as simulated by PODS-MIT), but the effort of pursuing a
second 10% improvement may not be worth. Maintaining forecast errors under control is a high

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opportunity cost task and we believe there is still much to improve by revenue management system
providers in this regard.
Forecasts should reflect the expected reality given all the available relevant information and given
the actions that have already been implemented and the decisions that have already been taken.
This is a relevant issue because revenue management systems typically have access to a very limited
diversity of variables (typically just incumbent airlines itineraries, flown passengers and bookings), so
they are blind in several dimensions, causing their forecasts to be slow at reacting to new external or
internal conditions in the market. By manually intervening the forecasts using additional information
not automatically available to the revenue management system, the pricing and revenue
management analysts should carefully adjust them, in order to accelerate the reaction of the system
and timely capture the revenue opportunities.

V. CAPACITY (OR INVENTORY) OPTIMIZATION


Differential pricing enables the airline to compound its revenues with an optimum mixture of prices.
With differential pricing the airline aims at capturing the highest willingness-to-pay (WTP) customers,
from the top to the bottom prices, till the airplane is full. This allows the airline to maximize the
revenue collected for the flight.

Inventory or capacity optimization, like the optimization of fare fences, may be regarded as a way to
segment supply. If the airplanes had no capacity constraint, supply segmentation via fare fences
could be enough to optimize revenue. However, given that the airplanes have fixed total capacity,
selling to too many customers at low fares will produce a displacement of customers willing to pay
higher fares, that is, some high WTP customers will not find available seats to buy, so the airline will
not be collecting the maximum revenue it could potentially collect and it wouldnt be satisfying the
expectations of some business customers who would have liked to fly with the airline. This is

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especially critical when high WTP demand manifests itself closer to departure than low WTP demand
(which is typically the case in most markets).

The optimal execution of the differential pricing strategy requires then that the airline protects seats
for higher WTP customers against the demand from lower WTP customers. However, since demand
is stochastic, determining the right number of seats to protect for higher WTP consumers requires
fitting a probability distribution for the demand (or a stochastic demand forecast). Based on this
probability distribution the airline has to perform a calculation of the trade-off between an additional
seat protected for a high fare and the same seat sold to a lower fare customer.
Expected Marginal Seat Revenue (EMSR)
The Expected Marginal Seat Revenue (EMSR) was proposed by Peter Belobaba in the 80s. EMSR
became a fundamental revenue management concept and is used at the core of most revenue
optimization systems in the airline industry. As its name suggests, the EMSR corresponds to the extra
expected revenue generated by an extra seat allocated (the marginal seat) to a given RBD (or
fareclass). ER(n), the expected revenue produced from n seats allocated to a given RBD, is obtained
by multiplying the price P corresponding to that RBD times the expected number of seats to be
sold. Given there is an upper limit of n seats to be sold, the whole probability of selling n or more
seats contributes to the scenario of selling exactly n seats. So, ER(n) can be computed as:
n1

i=1

i=n

ER(n) = P { i P r(D = i) + n P r(D = i) }

(IV.1)

Where Pr(D=i) is the probability that the demand D for seats equals i (with i an integer that can
take values from zero to infinite). How does ER(n) change if we allocate one less seat in this RBD?
Using the formula above the expected revenue for (n-1) allocated seats would be:

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n2

i=1

i=n1

ER(n 1) = P { iP r(D = i) + (n 1) P r(D = i) }

And, subtracting the two expressions we obtain the EMSR(n), the expected marginal revenue of the
nth
allocated seat
EMSR(n) ER(n) ER(n 1)

= P { (n 1)P r(n 1) (n 1)P r(n 1) + (n (n 1)) P r(i) }


i=n

That is

EMSR(n) ER(n) ER(n 1) = P P r(i)


i=n

(IV.2)

So, EMSR(n) is the price times the probability of selling the nth
seat as the last seat allocated or
protected at that price.
Optimizing seat allocation, general algorithm (leg based revenue management)
Lets now solve the seat allocation optimization problem for a flight (this problem is know as leg
based revenue management), assuming the airplane has a total capacity of C seats and that we have
a fare structure of just two prices P1 (higher price) and P2 (lower price). We aim at maximizing the
the higher price (and
expected revenue of the flight ER(n) as a function of the protection level n for

thus, a booking limit of C-n for the lower price):


Max{n integer

[0,C]}

ER(n) = ER1(n) + ER2(C n)

(IV.3)

Where ERi(n) is the expected revenue associated to price Pi when a maximum of n seats are allocated
to it. Given that the probability of selling a first seat allocated to P1 is close to 1 and that P1 > P2, the
ER(n) starts at zero as a rapidly increasing function of n. If the optimum n lies within the range [0, C]
then it should comply with the condition that increasing it by 1 will reduce the value of the objective
function ER(n), so the optimum value of n, lets call it N1, is the maximum protection level for which
the expected revenue increases:
N 1 = Max {n : ER(n) ER(n 1)}

(IV.4)

Using (IV.3) in (IV.4) and replacing the resulting terms by the definition of EMSR (see (2)) yields the
following expression, which is the condition for optimality:
N 1 = Max{n : EMSR1(n) EMSR2(C n + 1) }

(IV.5)

(EMSRk(n)
stands
for the EMSR of the nth
seat allocated to the price Pk ). In case of three prices, we

first compute N1+2 , the aggregated protection of the two higher prices (using the aggregated
probability distribution of the two higher prices and the corresponding expected price) and then we
perform a new two price protection optimization using expression (IV.5) where we replace C for N1+2
to compute N1 . So, expression (IV.5) can be used recursively for any number of price levels in order to
perform a general optimization of protection levels.

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Let us now work an example. Lets assume we have just three price levels (I will omit $
symbols) P1 = 1000, P2 = 700 and P3 = 500 and that demand for each price level distributes
Poisson with means 5, 15 and 30 respectively (I will defy the typical use of Normal
distributions, not just to be different, but also because Poisson may be a better
approximation to reality when demands are small integer numbers). Lets assume the
airplane cabin has a total capacity C = 25. The graph and table below show the EMSRs of all
prices, including the EMSR of the compounded demand for prices 1 and 2 (the sum of two
independent Poisson variables distributes Poisson with mean equal to the sum of the
means), as functions of n (the number of protected seats for each price), as well as
required for the optimality condition (IV.5). We clearly see that the condition
EMSR3(C-n+1)

(IV.5) applied to the compounded demand for prices 1 and 2 is satisfied for n=18, because
EMSR1+2(n = 18) = 544.8 EMSR3(25 n + 1 = 8) = 500

and
EMSR 1+2(n + 1 = 19) = 479.4 < EMSR3(25 n 1 + 1 = 7) = 500

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Now that we have 18 seats protected for the compounded demand of prices P1 and P2 we
apply again condition (IV.5), now with C = 18, to get the protection for P1 , which, from the
EMSR table above (by comparing the second and last lines) we see it equals 5 (given that
> EMSR2(18-5+1)=446
and EMSR1(6)=384
< EMSR2(18-6+1)=513).
EMSR1(5)=560

Once we have calculated all the protection levels for higher compound prices and for the top
price, we shall proceed to compute the booking limits, ie the maximum number of bookings
that will be allowed at each price level. The booking limit for the top price should be set
equal to the capacity of the airplane, since we wouldnt reject anybody willing to pay the top
price (many airlines, in order to compensate for no shows, allow overbookings, so the
booking limit of the top price could slightly surpass the capacity of the airplane). The booking
limit for the second price equals the booking limit of the top price minus the protection
required for the top price, that is 25-5=20. The booking limit of the third price equals the
booking limit of the top price minus the protection of the combined 1+2 prices (ie 25 - 18 =
7), and so on. In summary, we get the following protection levels and booking limits:

Littlewood rule
Typically lower price demand is much bigger (ie 2 >>
1 ) and it arrives earlier than the higher price

demand, so we can make the following approximation:

EMSR2(m) = P 2 P r2(i) P 2
i=m

(IV.6)

for m such that 1< m << 2. That is, the first m seats of the lower price P2 have all a similar EMSR,
which can be approximated to P2. As we saw in the example above, one key feature of EMRS(n) is
that it is monotonically decreasing in n, because the higher the number of seats protected, the lower
the probability that the last seat protected will be sold. So, if we start increasing the protection level
for price P1 , at some point the EMSR of the last seat protected for P1 will be smaller than the EMSRs
of any of the first m seats that could be protected for the next lower price P2. At that point, we
should stop increasing the protection level of P1 in order not to displace higher expected value
customers. That is, there exists an n = N1 so that
N 1 = M ax {n : EMSR1(n) P 2}

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(IV.7)

and N1 represents the optimum protection level for P1 from its next lower price P2. This is known as
the Littlewood rule. What Littlewood is basically assuming is that the demand of the next m seats
(for a sufficiently large m) at the lower price is certain. When the expected demand at the lower price
is a small number or as the airplane fills in with bookings, Littlewood rule may cease to be a good
approximation.
EMSRa & EMSRb optimization algorithms
The EMSRa algorithm, first introduced by Peter Belobaba in 1984, calculates the protections using
Littlewood rule for each higher price against a given lower price and then adds up the resulting
protections to determine the total number of seats to protect for all those higher prices from the
selected lower price; this calculation is then repeated for each of the lower prices from the bottom of
the fare structure up to the second highest price.
Using the same data of the previous example we can compute the protection levels and booking
limits resulting with the EMSRa algorithm as follows:
First compute protections for P1 and P2 from P3 using Littlewoods rule. From the EMSR table
= 560 >= P3 and
above we get that protections for P1 from P3 equal 5, given that the EMSR1(5)

= 384 < P3. Similarly, we get 13 for P2 from P3, which gives a total number of seats to
EMSR1(6)

to 5+13 = 18 for prices P1 and P2. Next we calculate the protections of


protect from P3 equal

P1 from P2 reading the table above, which gives a total of 4. Thus, the booking limit for P1 is
the capacity of the airplane, 25; the booking limit for P2 is 25 minus the protection for P1 , that
is 25-4 = 21 and the booking limit for P3 is 25 minus the protection for P1+2, that is 25-18 =7:

The EMSRb algorithm, proposed by Belobaba as an improvement to the EMSRa algorithm, instead of
adding up the protections of higher prices against the selected lower price, it applies the Littlewood
condition to the aggregated probability distribution (along with the corresponding expected price)
of the higher prices against the selected low price. EMSRb is a better approximation than EMSRa
because it computes the real EMSR of an additional seat protected for the higher prices as a whole,
from the corresponding lower price.
Using the same data of the previous examples we can compute the protection levels and
booking limits resulting with the EMSRb algorithm as follows:
First compute protections for P1+2 from P3 using Littlewoods rule on the EMSR1+2 of the
aggregated demand of the higher prices. From the EMSR table above we get that protection
for P1+2 from P3 equals 18 (which in this example is the same as in EMSRa, but it shouldnt
necessarily be the same in all cases). Then compute the protection of P1 against P2, which is 4.
Having calculated the protection levels the procedure for getting the booking limits is exactly
as in EMSRa, so we get the following results:

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Note that in this very simple example EMSRa and EMSRb produced exactly the same output (which,
as we noted, will not always be the case), however, both protect one seat less than the general
optimization algorithm in P1 (4 vs 5 seats, respectively). This is a consequence of Littlewood
approximation, which is used in EMSRa and EMSRb, because it overestimates the EMSRs of lower
prices.
The allocation optimization concepts and algorithms discussed here are typically used in leg based
revenue management, that is, in the optimization of seat allocations for independent flights.
Network Optimization
Also known as Origin-Destination or O&D revenue management, network optimization sets the
availability of seats for the different price levels (or fare products) of all the flights of a network,
aiming at the maximum expected net revenue of the whole flight network, as opposed to a specific
flight (which is the case of leg based revenue management).
Several algorithms have been developed to compute the optimum network availabilities, among
which we highlight Dynamic Programming. These algorithms are computationally intensive and
currently they require heuristic approximations in order to converge in a reasonable time at a
reasonable cost.
The concept of Bid Price has been introduced in network optimization to control inventory in a
more granular and dynamic way. Bid prices reflect the opportunity costs of all the available seats in
all the flight legs of the network. Bid prices are frequently recomputed and informed to the
reservation system of the airline, so that new bookings are confirmed in an itinerary only if the price
being offered or paid by the customer is at least equal or greater than the sum of the bid prices of
the seats being taken by the booking.
Network optimization adds an estimated 1.5% - 2% extra net revenue to the bottom line of the
business over leg optimization in a relatively connected high load factor network (ie a network with
at least 40% connecting traffic and 80% average load factor).
Although from a business point of view network optimization makes more sense than leg
optimization, from a system and from an organizational point of view O&D optimization is a highly
complex process, much more complex than leg optimization, so it should be no surprize that it
requires more team and more supervision than leg optimization.
Hybrid Models
Finally, there is a third generation of algorithms that deal with seat allocation optimization in low fare
markets, that is, in markets with fare structures that have weak or no fare fences. These are called
the hybrid models or low fare models. These models aim at recovering part of the diluted

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revenue by estimating the diluted demand and adjusting booking limits of lower prices RBDs
accordingly.

VI. ORGANIZATIONAL CONSIDERATIONS


Given the way prices and inventory interact (unavoidably linked through the demand function), and
given the highly tactical nature of revenue management, pricing management and capacity
management functions should both report to one role (typically the Route Manager) responsible for
the maximization of the route RASK (revenue per available seat kilometer). Some airlines keep these
functions separate with no joint tactical accountability for the route RASK, which is suboptimal.
Pricing strategies affect capacity strategies and vice-versa. In fact, when demand and load factors are
high, the emphasis of the revenue management process should go to capacity optimization,
especially to avoid displacing high yield customers. When load factors are low, the emphasis should
go to the fare structure optimization, especially to avoid dilution of high yield customers and
stimulate low yield demand.
A robust revenue management process is sustained on skilled and motivated teams managing
adequate systems and making timely decisions based on the right information. The revenue
management process requires dashboards, KPIs, accountabilities and ownerships clearly defined.

CONCLUSIONS
Revenue management teams empowered by the right technological platforms and systematically
leading robust commercial processes may provide substantial value to the airline business,
converting revenue management into a strategic weapon and a competitive advantage.
The effectiveness of revenue management in a business with high combinatorial complexity like the
airline business discipline will is far from stagnant, we envision years of interesting applied research
and new developments that will help the best practicing airlines maintain a profit advantage.

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