Airline Industry: Pricing Structure and Strategies Essay

ABSTRACT The profitability of an airline industry depends on filling seats, and on the company’s ability successfully to anticipate the cost and price structures of their competitors. However, many airline carriers have a hard time accomplishing this because the average airline passenger just needs to travel from one destination to another in the most convenient and shortest amount of time at a reasonable price. Therefore, customers in this market are not as loyal to one specific airline (brand) in the industries. The reason for this is that airline carriers provide the same services at similar prices. In addition, the passenger will only incur high switching costs if they choose to take another mode of less desirable transportation. Airline carriers have overcome these problems by using the strategy of â€Å"Price discrimination.† That is a strategy that allows them adequately to segment their potential passengers, and to offer different pricing structures that match passengers’ sensitivity to price and value differences in cost to serve, and their different competitive positions (Stern, 1989). While it also allows passengers to maximize their â€Å"expected utility† when flying with the airline carrier that meets their needs. The 1978 deregulation of the airline industry has resulted in airline carriers being unable to make a profit by filling seats, and successfully to anticipate the cost and price structures of their competitors (Bailey, David, Graham, Kaplan 1985). According to statistic, the airline industries’ profits declined in 2001 through 2003 by $23.2 billion (Smith Jr. & Cox). During this time the average airline passenger just needed to travel from one destination to another in the most convenient and shortest amount of time at a reasonable price. However, because all airline carriers provide the same services at similar prices, the passengers in this market are not as loyal to one specific airline (brand). For, example, any passengers not able to purchase a flight plan that they value, will not necessary buy the next best plan offered. Instead, these price-sensitive passengers will gravitate toward a lower-cost competitor  airline (Smith Jr. & Cox). This is especially true in this particular industry because a passenger will only incur high switching costs if they chose to take another mode of less desirable transportation. Therefore, many airline carriers had a hard time making a profit or breaking even (Brady, & Cunningham, 2001). In addition, this same deregulation of the industry provided new companies the opportunity to enter an already competitive market (Bailey, David, Graham, Kaplan. 1985). This stressed the market because pricing strategies that airlines used in the past did not adequately different between price sensitive passengers and price insensitive in this market (Sterns, 1989). Therefore, many airline carriers could not â€Å"capitalize on opportunities that [would] influence customer and [their] competitor responses (Stern, 1989). Because of this lost of profit, many airline carriers were force to file bankruptcy (Brady, & Cunningham, 2001). Therefore, as a reaction to these, external pressures many of the remaining companies (American, United, Continental, Northwest, US Air, and Delta) developed complex pricing strategies that would help them to outmaneuver their rivals (Smith Jr. & Cox). Different pricing structures were developed that allow them to match passengers’ sensitivity to pr ice and value differences in cost to serve, and their different competitive positions (Stern, 1989). In addition, sense airline carriers offer a product that is homogenous; to be successful they had to offer a product that potential passengers would view as different from their competitors’ product (Westermann, 2005). One strategy that airline carriers’ use is â€Å"differentiated pricing, which is a form of â€Å"price discrimination.† That is a strategy, which many companies’ uses because it allows them to charge different prices to different customer. However, airline carriers use this strategy by offering fare discounts.[1] This strategy allows the airline carriers to get as much consumer surplus as possible from each group of passengers, given his or her utility functions and income. Once they have determine their potential passengers expected utility from flying and income â€Å"Pricing ladders† are then used to charged for seats on a flight by segmenting travelers by their identity, destination, number of days between the day of reservation, the day of travel, the day, and time of departure, the day and time of return (Currie,  & Simpson, 2009). Many airline carriers and other companies are able legally to accomplish price discrimination and use pricing ladders because not all passengers have the ability or willingness to pay the higher or lower prices when they are offered (p.331 ). Identifying price discrimination Placing restrictions on purchase and use â€Å"Price discrimination† is a way to increase prices to improve profit margins by offering substantial discounts on bundles (McAfee, 2008). Price discriminate is accomplished by airline carriers’ when they offer potential passenger that satisfy certain demographics considerations a range of packages, or combinations of fares and restrictions attached to the purchase of their tickets (Stavins, 1996 & Anderson, & Renault, 2008). This pricing discrimination strategy â€Å"†¦ is known as second-degree or self-selection price discrimination (Stavins, 1996). Under this strategy, the airline is able perfectly to segment potentials passengers into groups according to their willingness to pay (Currie, & Simpson, 2009). Airline carriers are then able to offer them the highest fare in the ladder that they are happy to pay (Currie, & Simpson, 2009). While at the same time allowing passengers â€Å"†¦to choose [other] preferred versions of a product based on their willingness to pay for specific attributes of the good (e.g., time, convenience, flexibility)† (Stavins, 1996) [The citation for a direct quote needs the page number] . The pricing strategies is successful because it allow airline carriers to match â€Å"†¦the passengers relative ‘utility’ across competing products (where multiple factors are considered, including price, departure times, elapsed times, etc† (Ratiiff & Vinod). Therefore, companies were able to charge passengers on the same airline flight different prices for the same service and product. Nevertheless, several practices that involve selling services and or products for different prices can be viewed discriminatory (Anderson, & Renault, 2008). Airline carriers however justified this price discrimination by their cost differences and their demand-base (Anderson, & Renault, 2008). That includes â€Å"†¦the service quality/price sensitivity of various air travelers and offer differential fare/service quality packages  designed for each† (Smith Jr. & Cox). The second type of price discriminations that airline carriers use is the rationing and limiting of the supply of the cheaper goods (Stavins, 1996). One way airlines accomplish this is by adding various restrictions to cheaper or discounted tickets (Stavins, 1996). The discounted ticket is offered to passengers willing to stay at their destination a specific amount of time (Saturday-night stay over) or willing to purchasing their ticket in advance (Stavins, 1996). They also offer their potential passenger a discount or cheaper rate for their bundle roundtrips tickets. These are strategies that allows airline carriers to further separate â€Å"†¦price-sensitive passenger [that have a low disutility] from travel restrictions from price-inelastic [passengers that have a] high disutility from ticket restrictions† goods (Stavins, 1996). However, not all passengers value these types of discounts, especially business travelers. This is because even though this segment of passengers is less price sensitive, they are also less flexible concerning their flight arrangement (Stavins, 1996). Therefore, airline carriers can charge this segment of travelers premium seat fees because they prefer the flexibility that their one-way tickets offer. They also offer them frequent flier plans to help induce them to favor their particular carriers, even when ticket prices and restrictions are higher than their competitor (Stavins, 1996). â€Å"yield management† systems have also enabled airline carriers effectively to determine how many last-minute business travelers will show up willing to pay whatever it takes to get on a given flight (MCCARTNEY, 1997). Whereas, they charge this segment of passengers for their seats, leisure travelers on the same flight are offered a discount price, which is not necessarily based on the price of their ticket, but instead on the flight itinerary (Stern, 1989). These discounts and cheaper tickets are an economic value that this segment of passengers will obliviously value. This is because these potential passengers are more concern about price than the flight schedule (McAfee, 2008 Stavins, 1996). It is a pricing policy that allows airline carriers to provide a wider range of choices, which allow  potential passengers to determine the products and services that best meet their needs. Thereby, passenger satisfaction and loyalty is increased, and the airline carrier is also able to optimize their revenues by up charging different prices for the same seat on their airline (Stern, 1989). However, it is important to note that in today airline hyperturbluent environment airlines ticket prices change frequently in response to supply and demand and to changes in the prices of competitors’ fares (http://www.airlines.org/products/AirlineHandbookCh3.htm). This has resulted in many airline carriers unbundling services that traditionally came with the purchase of a seat, such as baggage checking, seat reservations and even the ability to pay by credit card. The benefits of these strategic practices have increased the revenue of airlines. It has also resulted in some passengers paying only for what the use. While for others that need to check a bag, and do not pay with cash, the cost of the seat will be more. Nevertheless, no company can price discriminate successfully, if they do not have some market power to charge prices above marginal cost (Stavins, 1996). In addition, they must have a diverse population of potential passengers, which they can adequately segment (Stavins, 1996). The â€Å"†¦product resale must be impossible or costly, to prevent arbitrage† (Stavins, 1996) [Needs page number] . The airline carriers’ industries however can accomplish price discrimination because of their hub-and-spoke systems (Stavins, 1996). These system allow different airline carriers to differentiate among themselves by â€Å"†¦occupying different slots in flight schedules, and by offering different route networks† (Stavins, 1996) [Needs page number] . These differentiation in flight routes, flight frequency, and airport dominance has allow many airline carriers obtain â€Å"†¦market power even on relatively competitive routes† (Stavins, 1996) [Needs page number] . Therefore, airline carriers may have market power in some market segments, but in others they do not, which results in higher price discrimination on their more competitive routes (Stavins, 1996). Conclusion Price discrimination is usually thought of as a way to extract as much consumer surplus as possible from each group of consumers, given his or her  utility functions and income. It is a strategy therefore associated with raising prices for less elastic consumers. But in the case of airline carriers, price discrimination is exhibited [Passive voice] through fare discounts. Consumers maximize their expected utility from flying. They choose between various price restriction packages, such as between low price-high inconvenience and high price-no restrictions combinations. The choice depends on the consumer’s elasticity of demand with respect to convenience, time, or money REFERENCES Anderson, Simon P., & Renault, Rà ©gis. August 2008. Price Discrimination. Retrieved 20 April 2010 from http://www.virginia.edu/economics/ Bailey, Elizabeth E., David R. Graham, and Daniel P. Kaplan. 1985. Deregulating the Airline. Cambridge, Mass.: MIT Press. Brady, Stephan, Cunningham, William. Predatory Pricing in the Airline Industry. :Transportation Journal; Fall2001, Vol. 41 Issue 1, p5, 11p Currie, Christine S.M., and Daniel Simpson. â€Å"Optimal pricing ladders for the sale of airline tickets.† Journal of Revenue & Pricing Management 8.1 (2009): 96+. 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(2001) â€Å"Price Discrimination in the Airline Market : The Effect of Market Concentration†, The Review of Economics and Statistics, 83, 1, 200-202. Stern Andrew, A. Pricing and Differentiation Strategies. Planning Review. Sep/Oct 1989, 17, 5. Retrieved 20 April 21, 2010, from ABI/INFORM Westermann, Dieter, (Realtime) dynamic pricing in an integrated revenue management and pricing environment: An approach to handling undifferentiated fare structures in low-fare markets: Journal of Revenue & Pricing Management; Jan2006, Vol. 4 Issue 4, p389-405, 17p, 4 http://www.airlines.org/products/AirlineHandbookCh3.htm