Airline Pricing and Profitability

Pricing and profitability are core to yield management strategies by industries offering time based products, such as airlines, hotels etc

The two most common strategies employed by airlines are:

1. Dynamic Price Discrimination with Price Commitment
2. Probability of Zero Capacity

Dynamic Price Discrimination with Price Commitment

The extent of price changes found in actual airline pricing can be quite interesting. An airline seat is a 'one-time use' good, allocated to a discrete time period. Potential buyer values are represented by a combination of demand and the price buyers re willing to pay.

The system must be capable of predicting how many buyers will buy during a certain advanced time period, by different price levels. The optimum time period-pricing level is the profit maximizing level.

Dynamic price discrimination focuses on new customers, rather than attempting to extract more profits from an existing set of customers by threatening low value customers with delayed purchases. That form of dynamic price discrimination is driven by customer dynamics rather than price discrimination over an existing set of customers.

Discrete time optimal pricing is very useful for its tractability. Once the arrival probability of customers per unit of time is assumed constant – the customer that takes a particular flight is less likely to take an alternative flight by the same airline. Potential customers demand a single unit, and their willingness to pay is determined by the available inventory.

With sufficient time and a given capacity, a flight sells out. However, since flights are time controlled, sufficient time is not a usable factor. The probability of selling all the capacity, is about the same as if the price was just constant at the monopoly price.

This leads to one considering whether an alternative to yield management and dynamic price discrimination, is to use constant fixed pricing. Whilst this results in lower profits than the yield management, the profits associated with a single price can still be maximized.

In a normal airline pricing curve, the price rises from the long term advance purchase fares, towards a standard pricing zone, then falls rapidly to support ‘last minute’ fares. By reducing available capacity for advance purchase fares, prices and profitability is driven up.

Probability of Zero Capacity

If dynamic price discrimination profitability is maximized at the static monopoly price, the per unit gain in profits of dynamic price discrimination over an optimally chosen constant price converges to zero, although the total gain will still be positive. This happens because most sales take place at an approximately constant price; dynamic price discrimination is advantageous only as the probability of actually selling out changes, for a relatively small portion of the very large number of sales.

This means that dynamic price discrimination only matters on the last twenty or so sales; over a large number of units are sold [100 or more seats], dynamic price discrimination doesn’t have significant impact.

The kinds of profits predicted, for reasonable parameter values, under dynamic price discrimination are not very large, less than 1%, when compared to an appropriately set constant price.

An important aspect of this conclusion is that dynamic price discrimination does not appear to account for the kinds of value claimed by some airlines using yield management.

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