Is there price discrimination in the US Airline Industry?
ECON 6350 Managerial Economics
Joshua Bautista – January 29, 2018
According to Froeb et.al, the definition of price discrimination is a method of charging or pricing differently to consumers depending on the changes in demand. This also means that charging different prices to buyers for the same product during the same period of time. Therefore, the price differences are unexplained by the cost differences. For instance, we have many elderly patients living in the Rio Grande Valley with close proximity to the Mexican border they have a better option to where they purchase medications. Pharmacological pricing is a prime example, U.S. residents choose to purchase their prescription medications for less than the price charge in Reynosa, Tamaulipas or even up north in the Canadian border.
As a Regional Director of Clinical Operations with Healogics, the largest wound management company, I fly with American Airlines for the past three years every week. Is there price discrimination in the U.S. Airline Industry? My answer to this question is a big yes because I’ve experienced price discrimination with airline tickets. In this essay, we will explore the economic conditions needed for price discrimination, discuss three methods of price discrimination, explain how variation may be due to pricing or a result of variation in cost, testing price dispersion, and lastly discuss the relationship between market structure and price discrimination.
According to McAfee, price discrimination (PD) occurs when these three conditions are encountered: 1. consumers differ in their demands for a given good or service, 2. firms have market power, and 3. a frim can prevent of limit arbitrage (2008). The basic theory of PD is relative to consumers having the same demands for a product. Buyers demand the same amount of the product for each price and the price and the quantity will depend on the number of buyers in the market and the ability of producers to supply the products also known as supply curve (McAfee, 2008). It is important to note that, “direct price discrimination is threatened by arbitrage, where consumers offered lower prices buy large quantities of a firm’s goods and sell these goods to other consumers who face higher prices” (McAfee, 2008). By placing restrictions on purchase firms can charge more price where the elasticity of demand is lower and can lessen the price from markets that price elasticity of demand is higher. The airline industry price discriminates by offering cheaper fares for those who stay over on Saturday nights, discounts for advanced purchase, discounts for a roundtrip, and point of origin discounts (McAfee, 2008).
Travelling every week, I’ve experienced being charge a higher price when my travel plans change immediately by purchasing a flexible ticket or when I need to travel either on a short notice. It is absolutely cheaper to travel with a two week out advanced purchase. Travelling in first class is also higher compared to travelling in coach class – I’m grateful that I’ve earned AA Platinum Pro over the years which gives me the automatic benefit to first class, no added fees for an extended-main cabin seat, and earn member points for free future flights – sounds like price discrimination at play because those who are frequent flyer members have an advantage. By the end of Q1 2018, I’ll be Executive Platinum. Keep in mind, that there are multiple factors that make aribitrage impossible: high transportation cost, legal impediments to resale, personalized products, think markets, informational problems, contracts, and warranties (McAfee, pg. 467, 2008).
Airline carriers have methods of price discrimination. Steen and Sorgard quote Varian (1989), the following definitions: first degree: seller charges a different price for each unit so that the price of each unit equals the maximum willingness to pay. Second degree: each consumer faces the same price schedule, but the schedule involves different prices for different amounts of the good purchased. Third degree: different consumers are charged different prices, but each consumer pays a constant price for each unit of the good bought (pg. 3, nd.). Do you notice the relation between the definitions above and the airline industry – quite a relationship.
The findings of Steen and Sorgard distinguishes that airline industry has three different types of price discrimination: versioning, discounts given to large consumers, and frequent flyer programs. Versioning is the quality of transport service where the more expensive tickets allow options for flexible travels without limitations. Price discrimination for the bulk purchase of multiple tickets at a discounted rate. Lastly, as a frequent flyer member like AA Advantage, their members are able to earn member miles for frequency in flights, member benefits like access to Admiral Club, and additional discounts.
Through the study of Borensteing and Rose, there is a substantial dispersion in the airline industry’s pricing. “The expected differences in prices paid by two passengers selected at random on a route is about 36 percent of the airline’s mean ticket price on the route” (Borenstein & Rose, pg. 644-655). The more challenging routes showed more price dispersion, while higher market density and concentrations of leisure travel appear to decrease price dispersion. Airport congestion also relates to higher dispersion with peak-load pricing (Borenstein and Rose, 1994). We learn that it is difficult to disentangle the sources due to product heterogeneities that affect the airline’s prices – for example, “the time and day of the week which travel occurs, ticketing restrictions, and the number of stops that a passenger must make – also may provide a basis for self-selective discrimination” (Borenstein and Rose, 1994).
It was revealed that the structure of the market provided evidence to impact the level of a firm’s price dispersion. As market progresses and grows, there are customer characteristic variations, major competition also peaks along with the need to hold constant flights to meet demands. As the frequency of flights increase, increase density and market share, the price dispersion lowers, and the “airport dominance by a carrier increases the dispersion of its prices on routes it serves from that airport” (Borenstein and Rose, 1994). More importantly, Borenstein and Rose noted that “the findings indicate that traditional monopoly theories of price discrimination may give neither complete explanations nor accurate predictions of pricing patterns in monopolistically competitive markets” (pg. 675, 1994).
As the market grows, the market also becomes highly competitive and has a confirmed relationship with price discrimination than in monopolistic markets. Stavin used, “marginal implicit prices of ticket restrictions as a proxy for price discrimination and compares those marginal effects across routes with various levels of market concentration to test whether airlines discriminate more on more-competitive routes” (2001). We learn that price discrimination lowers with lesser market density; Saturday-night over-stay and tickets purchased in advanced are with greater restriction; higher market concentration also where found with cheaper fares. In the contrary, airlines who share a market or higher market areas are proven to have a higher price discrimination. Stavin confirms, “the effect of market concentration was similar whether or not market share was included in the equation” (pg. 202, 2001).
Price discrimination is highly relevant, increasingly utilized, and prominent in the United States airline industry. In fact, it is likely to grow as we technology refines and as markets get more competitive. We identified that three types of price discrimination were versioning, discounts to large consumers, and loyalty bonus program or frequent flyers like AA Advantage. Our articles referenced encourages and requests additional empirical work to study the everchanging markets, to examine to other industries, and allow a better data separation of cost-based and demand-based price dispersion.