Airline Pricing

The main reference for this note is the ‘Airline Pricing’ chapter by Brenda A. Barnes in The Oxford
Handbook of Pricing Management, edited by Ozalp Ozer & Robert Phillips, 2012. Although the chapter is
based on the American airline industry and we might not fully relate to it, we will take and study from it
the ideas of pricing and revenue management and the organization and evolution of the industry and its
reach to consumers, which are similar to airline industries around the world.

Basic characteristics of air travel as a product:

 Perishable
 Fixed capacity (in the short run)
 Customer segments according to their private valuation (based on the purpose of flying,
sponsoring of airfare, etc.)
 Advance purchases, cancellations, arrival of passenger types by purchase timing
 Variable valuation of product according to date and time; stochastic demand turnout
 Possibility of separating categories of products by differing comfort levels, booking restrictions,
etc.
 Opportunity to price discriminate at various levels; some through above
 Large fixed costs of capacity and infrastructure, also large variable costs of fuel and labor, but
small marginal cost of flying an additional passenger
 Regulations
 Multi-stop travel and flight combinations
 Possibility of alliances between different airlines
 Distribution and agency markets

Price discrimination and customer segmentation:

The same origin & destination (O&D) route can have various different flights by time and/or layover
combinations. Even in an O&D with no stops, customers can value different flights by their scheduled
time alone. The most popular non-stop flight often has the highest fare, and the airline can limit the
number of discounted seats on this to ensure that later demand that is often higher valued is
accommodated.

Different flight times can also be targeted at, and thus help price to, different customer segments; recall
that this is second degree price discrimination, and the finer the airline can segment customers the
better it might be able to extract their surpluses and thus earn greater revenue. For example, weekday
morning and late evening non-stop flights might be preferred by business travelers more than by leisure
travelers, and as business travelers tend to be less price elastic these flights can be priced at higher
fares.

Many airlines, in the west especially, also award loyalty discounts to consumers in the form of frequent
flier miles that can accumulate with flying and can later be redeemed for add-ons (preferred seats,
upgrades, fees waived for baggage or flight changes, priority security or boarding, etc.) or even in
exchange for money for booking new flights. This not only segments customers by how much business
they bring the airline and give frequent fliers a rewarding (quantity) discount for loyalty, but also often it
limits the customers’ range of comparison of flights before purchase (eliminates some competition)
because they would rather accumulate points on one (or a few) airline(s) and thus limit purchases to
these rather than compare and purchase across the available range of airlines flying in their preferred
route.

Another popular way of segmenting customers by their valuation and income levels is the class
categories of flying – business, first, economy/coach, etc.

And yet another is to impose different degrees of constraining rules and conditions on the timing of
reservations and travel on cheaper airfare to segment customers into tighter and finer segments for
better price discrimination – these segments can also often be work vs leisure travelers both of who for
example might be buying the same category of seat. Such conditions can take the form of advance
purchase specifications, non-refundability clauses (that also deter cancellations), minimum stays at
destination, including weekends at destination, round trip requirements, etc. Work travelers will often
be willing to pay more for the convenience of choosing their timing of reservation and
travel/cancellations etc., while leisure travelers might be willing to give up on some conveniences for
lower airfares.

Despite all these efforts to segment customers according to their values/WTPs and to extract from each
category the highest possible fare, the end result can be such that customers don’t always purchase the
fare targeted to their category. Revenue losses due to this is called “dilution” which is the lost revenue
when a higher value customer purchases a lower airfare meant for another category of customer. To
minimize this, airlines need to segment airfare products into tighter categories with more constraining
restrictions/lack of comfort in the lower categories that force customers who have higher values to jump
to a higher airfare category. But on the other hand too many airfare products/categories also complicate
the airline’s pricing and inventory or availability management. There is a tradeoff between more
efficient and finer categorization of customers and greater complexity.

Pricing & Revenue Management:

For perishable products like air travel, pricing alone as a strategy is insufficient for an airline. It must also
do revenue management.

Pricing is all about designing and setting fare products/categories as well as add-ons. Pricing in such an
industry is also market-based rather than cost-based, which means that the goal is to have total
revenues cover fixed and variable (together total) cost and then make profits over and above that rather
than have each group of customers generate enough revenue to cover the cost of flying them. Fares or
prices can be set both publicly and/or privately (when agents or aggregator websites or cruises or
corporates/governments are given private discounts; more common for international travel). And can
be dynamically adjusted with increasing seats sold and changing forecasts for demand as time
approaches the date of departure.
The base airfare price is easily visible to competitors and compared by customers, and a price cut by one
can often set off a price war such that all competitors match the lower price. However, the fees set on
add-ons and frills is less susceptible to competition as customers often do not compare the final price
after adding all add-ons and fees.

A more recent trend in airline pricing has been to unbundle pricing for each added comfort or frill and
service; this is called ‘a lacarte’ pricing. Because add-ons are often/sometimes not compared by
customers or agencies before purchasing, they make airfare pricing more opaque and less susceptible to
competitive forces. They can also help categorize customers better by the degrees of add-ons different
customers are willing to purchase. Low cost airlines have especially embraced unbundled pricing.

Fuel charges are often accommodated by airlines through surcharges that are added to base fare and
are subject to taxes.

Revenue management (RM) on the other hand refers to determining and managing fare products’
availability and distributing availability through different channels. RM includes

- demand forecasting,
- overbooking,
- inventory optimization, and
- Network management.

These are less transparent/obvious to competitors and can thus be used by an airline to gain revenue
advantages more easily.

The demand forecasted includes both purchases and customers unable to do so because of insufficient
capacity (“spilled” demand). And also estimates of how many passengers will buy a higher priced ticket
when there is no availability at their earlier desired fare; this is called “sell-up” rate.

Because arrival of demand is often also separated by customer values – low value and highly price
sensitive customers tend to buy early while high value and low price elastic customers often purchase
closer to departure date, an airline needs to price and allocate availability accordingly. If it sells too
many seats at the lower/discounted price long before departure, then it will lose potential high value
customers (a higher revenue) who might desire purchase later when there isn’t enough availability. But
on the other hand, if it sold too few seats at the discounted price and waited for high value customers in
numbers that do not realize then it risks flying with empty seats and losing revenue on these. Littlewood
came up with a simple rule to assess availability and sale at discounted price at any point in time, given
reasonably accurate demand forecasting.

Littlewood’s rule1: Suppose there are two fare categories and the low fare/yield (r ) demand comes
before the high fare/yield (R) demand, and that C is the aircraft capacity and the airline has forecasted

1
Littlewood, Ken, “Forecasting and control of passenger bookings”, Journal of Revenue and Pricing Management,
4, 2, 1972.
demand for high yield, D h . To maximize revenue the airline should continue to sell/allocate low fare
seats, Al , as long as r ≥ Probability ( D h>C− A l )∗R . This can be extended to n fare classes/categories.

Overbooking is a critical part of RM, which also involves shifting passengers from flights with excess
demand to other flights with empty seats, preferably on own airline but if not possible then on other
airlines (which can necessitate purchasing those tickets at the last minute at high fares). Airlines
overbook flights to protect against cancellations and flying with empty seats by selling more seats on a
flight than there are available. Overbooking is rarely done in First Class, very conservatively in Business
Class, and aggressively in Economy.

There has been a recent trend in overbooking to use auctions just before boarding to buy seats off of
customers whose value for flying on that flight is low, to bring the overbooked flight back to capacity
levels. The passengers who give up their tickets are later confirmed on another flight with cash/travel
voucher incentives, the values of which are increasingly raised in the ascending auction till the airline
has enough customers giving up their seats. Travel vouchers are preferred to cash because customers
often forget to redeem them given the stipulated time, or use them to purchase tickets that often are of
greater value such that they still have to pay something out of pocket.

The oral ascending auction can also be replaced with a sealed bid auction in which customers are
privately (electronically) canvassed a little before departure as to their acceptable voucher/cash value in
exchange for their seat, and the lowest asks are used to trade with. This reveals less information to
passengers, possibly lowering their ask values. If the flight overbooks by too much then the cost of
accommodating these customers onto the next available flight is too high; on the other hand if
overbooking is too low the flight takes off with lost revenue on empty seats.

Network Management relates to comparing an itinerary purchase by a consumer, with multiple legs of
flights, with the best fares possible for those flight legs if sold otherwise (think ‘opportunity cost’), and
making this the basis of accepting/offering a reservation. Virtual nesting is also a part of network
management; this does seemingly the opposite but helps better network management: for any flight
leg, all possible combinations of itineraries are ranked by estimated revenue value and reservation
decisions are made by allocating each flight leg availability to an itinerary where it will earn maximum
revenue.

Demand forecasting is continuously evolving as do data capabilities. Customer choice-based modeling is

preferred to time series forecasting now and assumptions of demand on one flight being independent of
demand on another are being cast out. Remember the effectiveness of an airline’s RM depends critically
on the quality of its forecasting. Demand forecasting also needs to increasingly take into account how
unbundled fares, a la carte pricing, and add-ons affect consumer purchase rather than simply estimate
base fare effect.

And with increased consumer data being mined, airlines will/are move/ing toward customized pricing
and promotions, and to nudge customers into purchasing a higher fare category (upsell to them).

Regulation, costs, and evolution of the industry:

For each flight the average percentage of seats that must be occupied such that revenue covers
operating cost is called the break-even load factor (BELF). BELF has been increasing due to increasing
fuel, security, and labor costs, and due to lower airfares thanks to greater competition and deregulation
of fares, routes, and market entry & exit. As a result competition becomes even fiercer as small changes
in price can lead to BELF being met or not.

Airline industries around the world have evolved to a great extent in the last 40-50 years.

Earlier,

 Airlines used to be heavily regulated and thus there were fewer players in the market.
Government owned airlines. Elizabeth Bailey and the deregulation of airline prices.
 Bookings were often made through external travel agencies that were often large oligopolies
with substantial market power
 Internet bookings were miniscule, and data capability for demand and patterns forecasting was
less efficient
 Labor and security costs were low

Airlines were amongst the first industries to have a centralized and automatically updated inventory
repository or the computerized reservation system (CRS). CRS data is mined for demand forecasting and
analyzing trends and patterns in purchases. The dominant airlines in the US in the 70s started extending
their CRS to travel agencies in order to boost their sales and efficiency, but would prioritize their own
flights on agents’ computer screens. (This is similar to what Google has been accused of doing on its
search engine and Amazon on its marketplace display for its own brands.)

Regulations caught up with these problems to ensure unbiased display, and as owning CRS lost its
advantages airlines slowly divested their ownership in these.

Will not focus on the remaining, leave the evolution of the industry for students to read on their own.

Over time CRSs have evolved into what is today known as global distribution systems (GDS). These are
independent companies that provide electronic marketplaces and products that connect travel agencies
with suppliers (airlines, hotels, rental car companies, cruise lines, etc.); the largest GDSs are Sabre,
Travelport, and Amadeus.

Deregulation of entry, pricing, etc. on the other hand has led to the entry of a number of low cost
airlines, and has enabled airlines form large global alliances that have been granted anti-trust immunity
from coordinating schedules, prices, and inventory management. Star Alliance main players are
Lufthansa and United and it includes Air India, Air Canada, Air China, Swiss, Thai, Turkish Airlines, etc.;
OneWorld main players are American Airlines and British Airways, and includes Alaska, Qantas, Qatar
Airways, Sri Lankan Airlines, etc. ; and SkyTeam consists of Delta, Air France, KLM, and others.

Most airline alliances begin as code-sharing agreements between two or more airlines, in which an
airline sells seats on flights flown by another airline using its own flight numbers and airline code, such
that the two airlines price seats on the same flight independently and then share revenue according to
pre-specified conditions in the code-sharing agreement. A challenge to alliances is how to combine RM
and CRSs to improve combined RM.

Travel agencies’ commissions from airfare reservation and thus their control of the market has reduced
over the years, both because of the internet and easy online reservations that can be made by
customers directly and because of a concerted effort of airlines to reduce and cap commissions. But as a
result of the latter, GDSs in order to incentivize agencies and to retain their loyalty, started rebating
them the booking fees.

As rebates increased, so did the booking fees charged by GDSs in order to sponsor the rebates. This led
the airlines to try and bypass the GDSs by establishing direct links to their own online reservation
systems and their CRS. This has two main advantages – first, of course this helps cut out the role of the
GDSs and agencies and their commissions and fees, helping lower booking fees, but secondly it also
gives airlines more direct access to customer reservation data and helps improved forecasting and
demand estimation, and better customer segmentation for price discrimination.

But the internet and online commerce also benefited the business of travel agencies. Online travel
agencies (OTAs) were launched by Microsoft (Expedia), Sabre and its partners (Travelocity), etc.

Airlines still capped agencies’ commissions but OTAs could now move their focus to high value products
like holiday packages that included flights, hotels, and trips, etc. and added fees for their services of
search and bundling products. Some, for example Expedia even earned retailer earnings in between
discounted fares and hotel prices which they purchased and sold at higher consumer prices.

Moreover, OTAs provided comparison across airlines which individual airline websites did not.

Delta, United, Northwest Airlines etc. got together in response and launched their own OTA, calling it
Orbitz, which bypassed GDSs. Priceline and Hotwire were launched as independent OTAs that
subscribed to opaque pricing and entertained customer bids to compare with their private airfares from
airlines suppliers who benefited from allocating a few seats (that they did not expect to be sold
otherwise) to such unpublished fares and reaching very low value customers by segmenting them
separately from others.