Is there price discrimination in the US Airline Industry? essay
Price discrimination is a common practice used in the process of selling products and services; this is a strategy of pricing based on assigning different prices to customers basing on customer characteristics or group attributes. Price discrimination strategies relate to the customers’ willingness to pay. The purpose of this paper is to explore the existence of price discrimination in the U.S. airline industry, to consider the general market conditions that make price discrimination possible, to consider methods of price discrimination used by carriers in the U.S.,, to explore the causes of price dispersion and to assess the relationship between market structure and price discrimination.
According to McAfee (2008), price discrimination takes place when three conditions are satisfied: consumer demand for a particular service or good is different, when the firm has market power in the sense that it can charge the price higher than marginal costs are and when it is possible to avoid or prevent consumer arbitrage. Indeed, if consumer demand is uniform, consumer willingness to purchase goods will be equal so the reason for price discrimination will disappear. Furthermore, if the firm has no market power, it will be unable to charge higher prices and there will be no reasons for price discrimination as well. If customers are able to identify price differences and initiate arbitrage, those customers purchasing goods at lower prices will be able to resell to other customers and therefore there will likely be a single market price for the firm and a single (higher) market price for the end customers (McAfee, 2008).
In reality, there exist various factors preventing arbitrage – contracts, personalized services, high costs of transportation, legal regulations prohibiting resale, specific customer segment, limited availability of customers and lack of information (McAfee, 2008). In the case of airline industry, there are notable differences in customer demand (for example, business people are willing to pay more for urgent flights while retired individuals tend to choose cheaper flights), carriers have market power to charge above marginal costs and customers do not have possibilities for arbitrage because it is difficult to resell flight services (although there exist companies and agents reselling airline tickets). In general, the U.S. airline industry has the characteristics suitable for price discrimination and it is reasonable to expect that price discrimination is present in the airline industry.
Steen and Sorgard (2002) explore the methods of price discrimination used in the U.S. airline industry. According to their research, it is possible to identify three key types of price discrimination used by carriers: versioning, frequent flyer programs and discounts to large consumers (Steen & Sorgard, 2002). Versioning is the strategy of offering different air tickets with various options. For example, ticket versions with opportunities of rescheduling or canceling the flight are more expensive, while ticket versions with limits and restrictions are cheaper.
Another form of price discrimination in the U.S. airline industry is achieved through discounts to large consumers. Large companies have contracts with carriers and the employees of these companies can get a discount on their tickets. One more option is the use of frequent flyers programs (loyalty programs) by airline companies (Steen & Sorgard, 2002): members of such programs can accumulate bonus points for each flight and receive discounts or free flights using their bonuses. In addition, airline carriers might use price discrimination related to the time of purchase – tickets purchased beforehand might be quite economic, while the tickets purchased several days before the flight are more expensive. In this case, customer willingness to pay is estimated by the effort that the customer puts into the purchase of tickets.
Price variation might occur due to different reasons, the main of which are the seller’s willingness to receive additional profit (price discrimination) and variance in costs. According to Borenstein and Rose (1994), there exists certain self-selective discrimination in airline industry because of product heterogeneity and the dependence of costs on flight parameters (day of week, time, number of stops, etc.). Two major sources of genuine cost variations are systematic peak-load pricing emerging from the uncertainties of demand for airline tickets and stochastic load pricing based on the existing demand (Borenstein & Rose, 1994).
Signs of price discrimination are the differences in responsiveness to competition for different types of fares offered by the same carrier; if price dispersion increases with concentration, it is a sign of monopoly-type price discrimination and if price dispersion decreases with concentration, it is a sign of competitive-type price discrimination (Borenstein & Rose, 1994). Other factors stimulating price discrimination are variance of customer attributes, market density and market positions of carriers (size, market share, density of flights, etc.). Attributes of products affecting elasticity of demand also influence price discrimination.
The findings of Borenstein and Rose (1994) linking the type of price discrimination to market structure are further confirmed by the findings of Stavins (2001). The analysis of price discrimination options and restrictions used for price discrimination such as discounts for advanced purchase and Saturday night stay-over requirements shows that lower airfares are associated with greater restrictions, but directions with higher market concentration for particular carriers are associated with lower discounts (Stavins, 2001). Therefore, there is notable price discrimination in the U.S. airline industry with three key price discrimination types – versioning, discounts for large customers and loyalty programs, and the use of price discrimination is more intensive when market competitiveness increases.
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