Airline Pricing and Profitability
Pricing and profitability are core to yield management strategies
by industries offering time based products, such as airlines, hotels
The two most common strategies employed by airlines are:
- Dynamic Price Discrimination with Price Commitment
- 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
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
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
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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