Price Discrimination: Airline Tickets

First-degree price discrimination

First-degree price discrimination is also known as the purest form of price discrimination or perfect price discrimination. This is when a seller charges consumers the maximum possible price they are willing to pay.

Fig. 1 - First-Degree Price Discrimination

As Figure 1 illustrates, the producers get all the total surplus. In this case, there is no consumer surplus.

Second-degree price discrimination

Second-degree price discrimination occurs when a seller charges a different price for different quantities consumed. Examples of this are loyalty cards rewards or discounts for consumers, so that they can purchase more.

Fig. 2 - Second-Degree Price Discrimination

As figure 2 illustrates, firms initially put the price of a particular good or service at P₁. The discounted price is P₂. Consumers benefit from the lower price and that increases their consumer surplus and firms also benefit from the extra revenue.

Third-degree price discrimination

Third-degree price discrimination occurs when a seller charges a different price to different customer groups. A classic example is some cinemas that often have different prices for children, students, adults, and the elderly.

Fig. 3 - Third-Degree Price Discrimination

Figure 3 illustrates third-degree price discrimination. The whole market is split into two categories: elastic and inelastic consumers. Firms charge elastic consumers the lowest price. For example, cinemas charge students a lower price since they have less disposable income and are more sensitive to price changes. Inelastic consumers are charged the highest price. In our cinema example, adults tend to be charged the highest price as they have more disposable income and are less sensitive to price changes compared to other groups.

Types of pricing strategies adopted for airline tickets

Airlines use a combination of price discrimination and dynamic pricing in the pricing strategy for airline tickets. In the airline industry, airlines practice price discrimination in a number of ways:

1. How far the travel date is: a ticket that is bought in advance is usually cheaper compared to a ticket bought at the last minute.
2. Travel peak times: travelling during the weekends tends to be more expensive than travelling during weekdays. Travelling during the summer or Easter holidays also tends to be more expensive.
3. Unsocial hours: travelling during the early mornings and late nights is cheaper, as fewer people tend to travel at those times.
4. Extras: customers usually have to pay more for seats (in the same class) with more legroom to for check-in luggage.

Airline tickets and third-degree price discrimination

In the airline industry, customers are usually grouped into two customer groups: leisure and business. This demonstrates that the airline industry tends to practice third-degree price discrimination.

Grouping is done this way due to the distinct behaviours between the two groups. Customers who are travelling for the purpose of leisure are more likely to be sensitive to price and so would tend to book in advance to get cheaper tickets. Leisure travellers take advantage of 'advanced purchase' discounts, as the prices of tickets gradually get more expensive as the day of departure approaches. This is also because leisure travellers would have more elastic demand due to their sensitivity to price.

People who travel for business purposes, however, need more flexibility in comparison to those who travel for leisure and so would book only a few days in advance. Airlines would take advantage of their more inelastic demand and charge at higher prices.

Airline dynamic pricing

A demand-based pricing strategy that solely relies on grouping passengers as either ‘leisure or business travellers’ is not the most effective discrimination as it does not accurately capture the consumer landscape.

That is why airlines today use what is known as a dynamic pricing strategy. This strategy takes into account real-time data on consumer buying patterns.

With the use of dynamic pricing, the prices of tickets change in real-time based on the market data. This involves things such as customer behaviour, competitor prices, and popular events such as music festivals (like Coachella). Other factors like fuel prices, ground handling, and the cost of carrying an additional traveller are also filtered into the prices of tickets.

Airline price discrimination example: Southwest Airlines

One real-life example of price discrimination in the airline industry is Southwest Airlines.

A randomly chosen one way trip from Philadelphia, PA (PHL) to Los Angeles, CA (LAX) on Tuesday, January 18 (a weekday) would cost between $366 - $456 US dollars. However, on Saturday, January 22 (a weekend) the same trip would cost between $127 - $217.

Weekdays tickets tend to be more expensive for this specific route, as it is a common assumption that customers who buy a weekday ticket are travelling for business purposes. They have inelastic demand as they must be in Los Angeles for work. They have no other option, so they are more willing to pay a higher price.

On the other hand, weekend tickets are usually cheaper because people who travel during the weekend do so for leisure. If prices are too high they would opt for cheaper alternatives. Therefore, they have elastic demand so airlines charge them lower prices.

It is also relevant to note that similar to other airlines, Southwest charges different prices at different times of the day: early morning and late-night flights are less expensive due to less demand.

Economic effects of price discrimination in the airline market

The engagement of the airline market in price discrimination has both positive and negative effects on all economic agents: consumers, firms, governments, and third parties.

Positive effects

Some of the positive effects of price discrimination are:

• Capacity. Charging at different prices enables airlines to make better use of their capacity. This means that they are able to ensure that customers use each flight optimally. It prevents waste in the form of insufficient seats being occupied in a flight. This can also have environmental benefits, as airlines would try to fill up flights, selling seats at the best price possible. In other words, it spreads out demand and prevents flight congestion.
• Revenue. If airlines only charged one high set price, they would lose elastic consumers. Being able to separate consumers based on different conditions allows them to continue to make revenue, even if the price is not at the profit maximising point.
• Lower price. Elastic consumers are charged a lower price compared to inelastic consumers. They benefit from the lower price. This lower price increases their consumer surplus and utility.
• Higher profits. Airlines benefit from inelastic consumers who are willing to pay higher fees. They receive higher profits which they can later use to re-invest back for research that will help them improve their ticket pricing strategy.

Negative effects

Some of the negative effects of price discrimination are:

• Loss in consumer surplus. Consumer surplus is extracted from inelastic consumers when airlines charge higher prices. Airlines benefit as they make supernormal profits, but inelastic consumers lose out.
• Potentially unfair. Price inelastic consumers, such as business travellers may not all be high-income earners. This may also be unfair and inequitable if they are charged a higher price. But we could argue that most companies wi¡ould pay for the tickets instead of the direct consumer.
• Administration costs. It costs the airlines a lot of money to separate the market and carry out extensive research into dynamic pricing. If these administrative costs are too high, airlines could pass it onto consumers through higher prices.