Pricing Economics of the Airline Industry

Introduction:

Since its deregulation and liberalization, the airline industry is becoming more concentrated and one of the most competitive industry in the present world. Essentially the most distinctive aspect about the industry today is the high level of variants in the costs charged with respect to factors like times, time, category etc, the differential pricing strategy adopted and the way airlines actually use them to operate a vehicle home competitive gain. This report seeks to show the price discrimination occurring in the Airline industry.

Airline Costs:

Pricing is regularly viewed as one of the very most critical part of any business; prices, in a way, makes or breaks an enterprise. In this age of high technology penetration, and increased competition, the emphasis laid on charging the right customers with the right price is becoming increasingly high. That is pretty obvious since costing helps companies enhance and capitalize on competitive benefits (Stern, 1989). Air travel industry is signified by way of a focused market and heavy competition between the players; additionally it is the one described by huge predetermined and operating costs. To include on to the above, the merchandise that comes is also perishable; hence in order to ensure and support profits in the competitive environment having a very efficient costs strategy is crucial. Also in this present time of increasing dissimilarities in the manner the customers perceive a product offering and the differences in the levels of buying forces of the consumers, succeeding on the market using the traditional 'set the costs at the marginal costs' will generally not recoup sufficient income to cover the large resolved costs and sunk costs engaged within the industry (Varian, 1996). The above is the clinching point behind the need for price discrimination and price dispersion over the industry. To attain an efficient means of repeating this, the airlines use an assortment of Produce Management, Rationing and Price discrimination by carefully segmenting its customer platform using the principle of price elasticity of demand. (Kambli, 2002)

Price Elasticity of Demand and Price Discrimination:

Price elasticity of demand is defined as a "measure of the responsiveness of quantity demanded to a change in price" (Sloman and Hinde, 2007). It is the foundation on which the entire pricing system of the air travel industry is situated upon. For developing an efficient and a highly effective pricing strategy of any business, knowing the purchase price elasticity of demand of the marketplace inside out becomes required for all the market sectors. Price elasticity of demand for a good is immediately related to the options of substitution for the good (Brons, 2002). A comparatively large number of substitutes will imply high price elasticity whereas having less it will force the demand to be inelastic.

In economic terms, acquiring the market's consumer surplus is the major reason for price discrimination. This surplus, in market with an individual clearing price, develops due to the fact; some customers (the low price elasticity segment) could have been prepared to pay more than the one selling price. Price discrimination transfers a few of this surplus to the producer/marketer from the buyer.

It can be proven mathematically, that a company facing a downward sloping demand curve that is convex to the origin will always obtain higher revenues under price discrimination than under a single price strategy. That is shown diagrammatically below.

Figure 1 : Sales Earnings without and with Price Discrimination

Source :Economics, John Sloman

In the diagram above, an individual price (P) is available to all customers. The area P, A, Q, O presents the amount of revenue. The area above line portion P, A but below the demand curve (D) is the consumer surplus.

With price discrimination, (second diagram in Amount 1), the demand curve is split into two sections (D1 and D2). (P1) is the bigger price incurred to the low elasticity section, and (P2) is the low price billed to the high elasticity section. The region P1, B, Q1, O is add up to the total revenue from the first segment. The region E, C, Q2, Q1 is equal to the total revenue from the second segment. Supposing the demand curve resembles a rectangular hyperbola with unitary elasticity, the sum of these areas will always be greater than the area without discrimination. A lot more prices, that are unveiled, the higher the sum of the revenue areas, and the greater of the consumer surplus is captured by the company.

Note that the aforementioned requires both first and second level price discrimination: the right part segment corresponds partly to differing people than the kept segment, partly to the same people, ready to buy more if the merchandise is cheaper.

It is very useful for the purchase price discriminator to look for the perfect prices in each market portion. This is done in Amount 2 where each portion is recognized as a separate market with its own demand curve. The Profit maximizing result (Qt) depends upon the intersection of the marginal cost curve (MC) with the marginal income curve for the total market (MRt). (Sloman, 2000)

Figure 2 : Earnings Maximising output under Third degree Price Discrimination

Source :Economics, John Sloman

The firm decides just how much the total productivity to market in each market. That is established from the marginal income curves in each market. The intersection of the marginal revenue with the total selling price curves in each market yields most effective outputs of Qa and Qb. The earnings increasing prices of Pa and Pb can be identified from the demand curve in each market.

Multiple SELLING PRICE Determination:

Airline industry is one where both elastic and inelastic demand habits co-exist and it is the key reason why the core tickets are cheaper compared with the add-ons like Fees, charge for extra baggage's etc. A small business passenger with the least price sensitivity, high time dependence, who books the tickets days and nights or hours before the journey is a perfect example for the inelasticity in the market. The surplus gained or produced by the airline out of this inelasticity actually amounts the diminishing earnings and discounts experienced in providing the elastic leisure vacationers with a higher sensitivity on price and relatively flexible schedules there by helping the businesses to sustain its profitability. Likewise, another theory which helps the industry in sustaining its gains is the segmentation of the marketplace, into price hypersensitive and the non price delicate segments and creating a segment based costs strategy - Third Degree price discrimination. Air travel industry sections their markets relating to school of travellers, like Luxury or first, Business School and economy course, reason for travel, like business or leisure etc and also on the quantity of demand for a particular root. Using these segmentations helps them to effectively get an information in to the consumers' willingness to pay and improve the removal of consumer surplus from every one of them. (Martijn, 2002)

Yield Management:

Yield management, also called income management, is a process of understanding, anticipating and influencing consumer behaviour in order to increase revenue or revenue from a set, perishable resource. Because the flight industry satisfies the three main basic essentials i. e. set and perishable resources and the differences in the clients willingness to pay, yield management is one of the most extensively used theory on the market. It also causes a competent way of operation and forms the foundation for the purchase price discrimination decisions taken by the organization. With regards to deliver management, airlines try to section the demand on the market by offering different combinations of price levels and limitation bundles or fare products made to appear in another way to consumers with different levels of determination to pay (Botimer, 1999). Based on the level of determination to pay airlines impose limitations (fences) on the lower fares to avoid other portion consumers from buying tickets at a discount. Couch allocations based on the above are achieved by the consumption of complex produce management systems which uses a nested property control mechanism to carry out the same. Another source of fare differentiation is Rationing. Segmentation and rationing exploit the difference in the willingness of the client to pay through different programs at different times with different levels of effort. (Kambli, 2001). Quite simply rationing can be discussed as the phenomena where the supply at the low price is limited and distributed among the clients. With rationing the airlines use fares to allocate their supply of limited seats among consumers. This is one way airlines deal with the apparently difficult price modifications and resource allocations proficiently and effectively and stay competitive on the market.

Equilibrium Point:

This is the stage where the organisation has no damage or gain. Airlines can work out through the demand and supply curves and can identify the break-even point where in fact the company suffers no damage, nor is there any gain. After evaluating this value, Airlines can determine how many

Figure 3 : Equilibrium price curve

Source : Earl and Wakeley, 2005

seats could be allotted under concessional price and how many could can be sold under the business enterprise category category. Say, the break-even point is at 50% of the entire seat tickets, where Airlines can run without making a damage even if all of those other tickets are not sold. In this case, Airlines can opt to sell a tiny ratio of the 50% at a discounted price. The remaining % of the tickets could be remaining for selling under the business class category. This might give a good margin of revenue for the company. (Earl and Wakeley, 2005)

Complications and Extensions:

The Implication of Yield management system has a multitude of complications. A number of the implications we face are reviewed below

Demand Forecasting:

When putting into action a yield management system we always utilize historical demand to anticipate future demand. In an actual application, we might use more complex models to generate demand forecasts that consider a number of predictable events, like the day of the week, seasonality, and special occurrences such as vacations. Another natural problem that comes up during demand forecasting is censored data, i. e. , company often will not record demand from customers who have been denied a reservation.

Variation and Mobility of Capacity:

Assuming that all items of capacity are same is one of the major drawbacks of the yield management systems.

Customers in a Fare Category aren't all equally:

A business traveller on an airplane flight may reserve a ticket on just one single leg or may be carrying on on multiple lower limbs. Not retailing a solution to the latter traveler means that income from all air travel hip and legs will be lost.

In each one of these cases, the total revenue made by the customer should be contained into the yield management calculation, not just the revenue produced by a single flight leg. You will find additional difficulties when code-sharing associates (distinct air lines that provide connecting plane tickets among each other) operate these trip hip and legs. If code-sharing occurs, then each one of the partners will need to have an incentive to consider the other partners' revenue streams.

Winners and Losers in cost Discrimination:

Yield Management in the Airline industry aims at maximizing income. But this technique makes customers either winners or losers. Consider a case where in fact the Economy class seating are filled up, with much chairs available running a business class. So whenever a passenger looking to book a Market class ticket, will get a seat available class, but will be priced with the Economy class fare. This makes that one passenger, 'A Champion'. Those other travellers traveling in the Business class become 'Losers', since they travel with a high fare than that particular passenger.

Figure 4 : Winners and Losers from Price Discrimination

Source : Lecture Notes

Conclusion:

Sustained profitability, occupies the very best spot in virtually any industry's vision declaration. It is the one, which drives companies in search of new techniques and solutions to ensure they conclude on the renewable, year on year. The above combined with industry's urge to achieve the highly competitive environment and effort to package deal their offerings within an attractive way to the consumers', sorts the key solution for the ever eluding puzzle of modifications in airline costs.

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