Airline Pricing: How Does It Work?

Airline Pricing: How Does It Work?

Airline Pricing: How Does It Work?

Introduction

This research paper seeks to explore the inner workings of how airline tickets are priced in the real world. It is important to understand the economic dynamics behind pricing actions and movements. Whenever someone travels or makes use of a commercial airplane, he or she plan accordingly every foreseeable element of the trip to avoid having any last minute changes that require re-booking and changing initial plans. A question comes to mind, why do we anticipate the trip as much as possible? One reason is that we, as consumers, understand that the closer we are to the date of the flight the more expensive it will be. Is that really the case? With this paper I will try to uncover and shed some transparency on this topic and ultimately understand how airline pricing works. It is important however to highlight that given the complex nature of the pricing model of airlines (stochastic calculus, statistics, discrete analysis, etc.), this paper portends to provide research that supports what we see in the marketplace with regards to pricing.

“The airline industry’s pricing system is a billion-dollar house of cards in which every customer is a futures speculator and Economics 101 is turned onto its head” (Fredrick, 1995).

The statement above portends a very telling situation and it harbors one of the biggest frustrations that we, as airline travelers, have against the industry. Airline pricing presents such an imbalance that passengers seated next to each other can have a price disparity of as much as 400%. The consideration here is that one would surmise that the passenger who has paid more would get an increased level of service or some type of differentiation. The bottom line is that this passenger gets nothing extra for that paid overage. The high paying passenger receives the same level of service and the same type of seat.

Historical Background

If we review the history of the airline industry we are flushed with many changing landscapes. In the past twenty years, a very minute number of industries have had such drastic changes as the U.S. domestic airline industry has undergone. The industry has shifted from being a structure of well-established airlines flying a regulated route structure to a free moving market where new entrants of the industry come and go seemingly overnight. In recent years, a clear picture, depicting massive market dominance by a small group of major airlines, has emerged. One thing is for certain, given its past penchant for volatility, the industry will continue to change over time. If we look to the past, regulation had a pretty tight grip on prices but that has changed. Airline pricing volatility is fairly a more or less recent phenomenon in the industry. From the very beginning, airlines in the United States have been subject to government regulation similar to that of public utilities. The Civil Aeronautics Act, passed in 1938, gave regulatory power to the Civil Aeronautics Board (CAB) to oversee the airline industry. This act’s main objective was to ensure proper sound economic conditions in the industry while looking out for the public’s welfare. The following areas: market entry, rate determination, and antitrust authority were regulated by the CAB. These regulation initiatives allowed the CAB to decide which routes airlines would fly and determine airfare rates which the CAB found reasonable. In addition, anti-trust measures were governed by the CAB, to mitigate or stop any form of anti-competitive behavior between airlines (Dempsy & Gotz, 1992). This regulation established a favorable environment and a group of flagship airlines arose and became known as the trunk carriers (11 airlines). During the next 40 years, the trunk carriers supplied 87% of the air travel needs of the United States (Bailey, Graham, and Kaplan, 1991). Over this time period, rates were kept higher than market by the CAB. In addition, the CAB made entry to the industry very restrictive, thus protecting the 11 trunk carriers from any new competition. A direct result of this action being that trunk carriers were more than willing to exist with each other as long as they continued to make consistent profits. They had a monopolistic competition. This was tarnished starting around the 1970s, when trunk carriers were all reporting record losses. The main driver of this situation was the over-demand of new aircraft put in place by the airlines. This heightened demand was in anticipation of forecasted booms in passengers travelling. The recession of the early 1970s hampered demand for travel and the trunk carriers begin to have the impact of the capital carry cost from their balance sheets trickle over to their operating losses. These operating losses were prolonged and made an impact (Bailey, Graham, and Kaplan 1991). A majority began to condemn the CAB arguing that they had failed to provide for public welfare mainly because the CAB had had created a monopolistic industry with inflated airfares. This was definitely the case, a good example of this were groups of interstate airlines had grown to provide more affordable air travel on their flights compared to the CAB regulated airlines. These interstate airlines were not subject to CAB authority as long as they flew within only one state. The most famous of these interstate airlines was Southwest Airlines, which flew in Texas. Southwest competed with trunk carriers on many routes and charged fares significantly lower, which generated greater air travel demand. More importantly, Southwest was also consistently profitable (Bailey, Graham, and Kaplan, 1991). This growing situation of prolonged operating slumps of the established airlines and the public outcry for affordable air travel paved the way for the passing of the Airline Deregulation Act in 1979. The result of this act was complete elimination of the CAB’s authority, leaving the airline industry in a free market. Almost overnight, a number of new airlines arose to compete with the trunk carriers and the industry changed forever (Glab and Peterson, 1994). After deregulation, many small, low-cost airlines came into the market. Focusing on cost effective facilities, using non-unionized workers, and saving on amenities, the smaller airlines had a strong price advantage and were able to capture a significant part of the major airline’s business. The major airlines (trunk carriers) could not lower prices because of their higher costs, and their assumptions that customers would continue paying higher prices because of brand loyalty and a higher level of service did not hold up.