Testing Theories of Price

Dispersion and Scarcity

Pricing in the Airline
Industry
Steve Puller
Anirban Sengupta
Steve Wiggins
Texas A&M

American: DFW-LAX All Tickets Sold in 2004Q4

$429

$248

$368

500

Roundtrip Fare ($)

1000 1500 2000

2500

$490

7
14
Days Purchased in Advance
Roundtrip Fare

Average Fare

21

Roundtrip Fare ($)

250
500
750

1000

American: DFW-LAX All Tickets Sold in 2004Q4

7
14
Days Purchased in Advance
Roundtrip Fare

Average Fare

21

Outline
1)

Overview of theory

2)

Data

3)

Tests
Tests turn on comparing pricing in high
demand versus low demand flights
Evidence supports some scarcity pricing
Stronger evidence that ticket
characteristics drive price dispersion

4)

Implications and future research

Two Classes of Theories We

Assess
1)

Scarcity pricing

Airlines have large fixed costs

Airline seats are perishable (lose value at
departure)
Demand is uncertain
Dana (1999) & Gale and Holmes (1993)
2)

Alternative Theories: Yield Management

Ticket restrictions create fences

Segment demand to implement second-degree
price discrimination

Which of these theories is the primary driver

of prices?

We test between these theories

Danas (1999) Model with

Perishable Goods and Uncertain
Demand

Stadium seating example

Prices set in advance

2 demand states High/Low w/ prob=1/2
Heterogeneous

consumers arrive & buy cheapest ticket available

MC of capacity = $20
Competitive Eqbm:
Offer X tickets at $20

Sell w/ pr=1 (in both High & Low)

Offer Y tickets at $40

Sell w/ pr=1/2 (only High)

Zero

profit condition Price = MC /

probability(sale)

Yields intrafirm price dispersion as a pure strategy

eqbm in a perfectly competitive environment (and
monopoly, oligopoly)
Do NOT need fences to get price dispersion

Predictions of Dana (1999)

Ideal setting: Analyst observes multiple
realizations of flights with same expected
load factor
same offered fares; different transacted
fares

Predictions of Dana (1999)

Ideal setting: Analyst observes multiple
realizations of flights with same expected
load factor
same offered fares; different transacted
fares

Predictions of Dana (1999)

Ideal setting: Analyst observes multiple realizations
of flights with same expected load factor
same offered fares; different transacted fares
On flights with higher realized demand
1)
2)
3)
4)

Higher mean transacted fares

More price dispersion
Larger share of high priced tickets
Flights with unusually high sales as of x days
before departure, will sell more high priced
tickets in last x days.

More Predictions of Dana (1999)

Low priced tickets sell out when
demand is high
2) Share of high priced tickets rises
1)

On peak flights
Near departure
4)

Gini will be higher on peak flights

Gale & Holmes (1993)

Contract
on
prices

Consumers learn
if prefer peak flight

Flights
Occur

Monopoly airline (Mechanism design problem)

2 flights peak and off-peak
Consumers:
Consumers prefer peak or off-peak
flight
Learn preferred time just before departure.
Vary in time cost of waiting.
Equilibrium:
Airline offers discounted advance purchase
tickets
on off-peak flight.
No advance purchase sales on peak flight.
Consumers self-select (low value of time
consumers buy discounted off-peak

Scarcity Pricing Theory

Predictions
Off-peak

flights sell fewer high-priced

seats (both theories)
A greater proportion of seats sold offpeak will be discounted fares (both
theories)
There will be more dispersion in fares
for peak flights (Only Dana)

Yield Management Literature

Airline

prices are set to charge

different prices to different groups of
customers
Airline customers vary in terms of their
willingness to pay to avoid restrictions
Tickets are allocated with various
restrictions, and are priced to
maximize yield

Ex Ante Fixed Fare Schedules

Common to Both Sets of
Theories

Price (fare) schedules are set in advance

The fare schedule is set by an airline pricing department

Fares define price for each combination of characteristics
(bucket)
Yield Management Department allocates seats to each bucket

Dana: sets of ticket prices chosen ex ante before any

demand information realized
Gale & Holmes: two types of tickets advance purchase
& spot
Yield management:
Planning (pricing) department chooses flight schedule (& fare
structure).
Yield management dept chooses seat allocated to each fare

Related Work Using Posted

Prices
Examples:

McAfee and Velde (2006)

Escobari and Gan (2007)
Borenstein & Rose

Our

work uses transaction prices and

quantities

Data

Use census of transactions for travel 2004Q4 from a

major Computer Reservation System (CRS)
Represents approx. one-third of tickets sold
Includes data from airline sites, on-line sales, travel agent
sales

Ticket level data include:

Origin-Destination
Carrier
Fare
Flight no.
Coupon level class of service
Dates: Purchase, Departure, and Return

Number of seats on plane (OAG)

Can calculate flight-level Load Factor
Scale

up by CRSs market share for that carrier-citypair.

(We will deal with attenuation bias later)

More detailed than DB1B

Difficult to assess peak-load pricing without information on

load factor

Data (continued)

Also need data on ticket characteristics/restrictions

Use data from another CRS2 that includes

restrictions including

Refundability and advance-purchase restrictions

Travel restrictions (e.g. day of week)
Stay restrictions (Minimum and/or maximum)

Match each observed transaction to CRS 2 based on:

Route
Carrier
Departure Date
Fare
Keep if fares match within 2 percent
- Ensure other restrictions satisfied (e.g. days of advance
purchase, days of travel, stay restrictions)

Matched 36% of transactions

Matched versus Unmatched Sample Means

.001

.002

.003

.004

.005

Matched v. Unmatched Fare

Distributions

500

1000
Roundtrip Fare

Unmatched Transactions

1500

2000

Matched Transactions

Final Ticket Level Data

Contain

Fare
Carrier
Route
Flight number
Flight dates (departure
and return)
Calculated average
load factor
At departure
At date of purchase

Ticket characteristics
Refundability
Travel restrictions
(e.g. day of week,
length of stay)
Stay restrictions
(e.g. minimum or
max stay)
Booking class
Saturday stay-over
Round trip and direct

Exclude first-class, open-jaws, circular trips, Holiday travel, > 4 coupons,

Airlines and Routes

1 sd
= .045*.34 1 sd
= 1.5%
= 2.3%

1 sd
= .045*.34
= 1.5%

1 sd
= 2.3%

Illustration of Mismeasurement
of Load Factor
Consider

120

Distribution of Our Measure of Load Factor for Plane with LF=75%

100

Frequency (1000 simulated fights)

100 seat
plane with 75
passengers
Suppose our CRS has
1/3 market share
Simulate observing
each ticket w/
pr=1/3, and scaling
up our observed #
tickets by 3

80

60

40

20

0
20

40

60
80
100
Our Measure of Load Factor

120

140

Attenuation Bias in
Load Factor Coefficient?
Use

( X ' X N ) 1 X ' y

Empirical Approach to Testing

for Scarcity Pricing
1)

Test price rigidities assumption

(common to all models)

Data generally consistent with

assumption

Test Predictions of Dana and Gale &

Holmes
3) Test whether fares higher on
unusually full flights
2)

Testing for Price Rigidity:

Motivation
Consider

Danas stadium pricing

Prices for two types of tickets ($20 & $40)

Data on all tickets and ticket type (perhaps
slightly measured with error)
Farei = 0 + 1Typei + i
2
s are mean fares, R 1

Farei = 0 + 1Typei + 2LoadFactori + i

2 = 0 fare not adjusted to LF
Greater share of $40 seats sold when
demand/LF are high

Gale & Holmes (type=advance purchase/not advance purchase)

Yield management (type = fences)

Testing for Price Rigidity

Ticket types are Bins, each with its owns fare

For each route:
Log(fare)i = f(Bin Dummiesi * Carrieri, Roundtripi, i)

72 bin dummies all possible combinations of

Refundable
x
Travel and/or stay restriction
x
Saturday night stay
x
9 categories of advance purchase restriction (None, 1
day, 3 day, 5 day, 7 day, 10 day, 14 day, 21 day, 30
day)

Testing for Price Rigidity R2

Density
4

Median = 0.84
Mean = 0.78

.2
.4
.6
.8
R2 of log fares on dummy variables for bins

40

Testing for Price Rigidity Load

Factor

10

Density
20

30

Median = 0.028
Mean = 0.043

-.1
0
.1
.2
.3
Coefficient of Actual Load Factor Averaged Across Flight Segments

Testing for Price Rigidity:

Summary
Ticket

characteristics explain bulk of

price variation
Controlling for ticket characteristics,
Load Factor is associated with slightly
higher fares
Results largely consistent with price
rigidity assumption

Testing Dana and Gale/Holmes

Quantity Allocation Predictions

These theories make specific

predicitons regarding the allocation
of ticket types:
1) Share of low-priced tickets is lower in
high demand states
2) On-peak flights will have a smaller share
discount tickets
3) Off-peak flights will have more
discounted advance purchase sales

Predictions on Price
Dispersion

Predictions on Price
Dispersion

Measuring Expected & Realized

Load Factors

Expected Load Factor

Define Flight No./Day-of-Week (FDOW)

Measure mean load factors for 12 weeks for

FDOW
Sort FDOW into Empty, Medium-Empty,
Medium-Full, Full

Realized Load Factor

Within each category of Expected LF, rank

individual flight/departure dates by load
factor at departure
Separate into 4 groups

Predictions on Price
Dispersion

Testing Dana and Gale/Holmes:

Quantity Allocation Predictions

Theories make specific predictions

regarding the allocation of ticket
types:
1) Share of low-priced tickets is lower in
high demand states
2) On-peak flights will have smaller share of
advance purchase/discount sales

Need to define discount tickets

Define Discount Tickets

Using Characteristics

High Priced/Refundable Tickets (Group 1)

Medium Price/Nonrefundable/Unrestricted Tickets (Group 2)

Fully Refundable
Few if any restrictions
Mean fare = $631
26% of tickets

Nonrefundable, but
No travel or stay restrictions
Mean fare = $440
32% of tickets

Low Price/Nonrefundable/Restricted Tickets (Group 3)

Nonrefundable
Travel and/or stay restrictions
Mean fare = $281
42% of tickets

Dana

Dana

Gale/Holmes (advance purchase)

27%

27%

32%

29%

35%

31%

Gale/Holmes (advance purchase)

36%

32%

17%

15%

44%

40%

Testing Dana, Gale/Holmes, &

Scarcity Pricing: Price
Predictions
Pricing Prediction

Average prices will be higher when flights

are full, particularly near departure (Dana)
More advance purchase tickets sold on
off-peak flights, and so higher average
fares on peak flights (Gale & Holmes)
Generally
Scarcity Pricing would suggest higher
average fares during peak times

Dana: Predictions for Price

Levels
Stadium

Thought experiment

Suppose consumers arrive at different

periods before event
Suppose an unusually higher number of
seats sold 2 or more hours before event
(T-2, T-3, )
Then tickets purchased 1 hour before
event
(T-1) will be sold at higher
prices

Are Fares Higher when a Flight

is Getting Unusually Full?

Measuring Load Factor Deviations

Measure mean load factor for particular days in advance at
the carrier/route/day prior level
E.g.,

mean share of seats sold 7 days before departurefor all

flights on a route

For each flight/route/date/day prior, calculate load

factor, and determine % deviation from mean
(Load factor for flight/date/day prior mean) / mean =

% Load Factor Deviation

Similar calculation for Fare Deviation

For a ticket bought 7 days before departure, if the plane is 10% fuller than
normal (for a plane 7 days before departure), what % more expensive is
the fare?

Comparison Across Carriers

(measured in % deviation)
Slopes:
American .17
Others .08

-.2

Fare's Pct Deviation

-.1
0
.1

.2

Last 7 Days

-1

-.5

0
Load Factor's Pct Deviation
American
Continental
Northwest

.5
Delta
United
USAir

Only Last 3 Days

(measured in % deviation)

-.2

Fare's Pct Deviation

-.1
0
.1

.2

Last 3 Days

-1

-.5

0
Load Factor's Pct Deviation
American
Continental
Northwest

.5
Delta
United
USAir

.5

.45

1
1.5
2
Variance of Arrival Rate

Coef of Variation in Fare

.5
.55
.6

2.5

.65

Dispersion in Fares
As Approach Departure

7
14
Days Purchased in Advance

Coef of Variation in Fare

21

Variance of Arrival Rate

Dispersion vs. Load Factor

Coefficient of Variation as Function of Load Factor
One Way Trips
Coefficient of Variation
.12 .14 .16 .18 .2

Kernel Regression

.4

.6

.8
Flight's Load Factor

1.2

Note: Kernel regression of coefficient of variation vs. actual load factor us

one-way tickets on each flight. Obs = carrier-route-flightNo-departure dat

Conclusions and Ongoing

Work
Some

evidence consistent with Dana and Gale

& Holmes
Statistically significant effects on quantities
Economically modestreallocations of 3-7% of
seats

Much

stronger evidence that ticket

characteristics drive variation in pricing
While not ruling out pricing model based on
perishable good & demand uncertainty,
suggests that ticket characteristics that
segment consumers play a larger role.

Interpretation
Actual

airline decision is a
complex OR problem
To solve the system-wide yield-management problem
would require approximately 250 million decision variables.
Because this mathematical programming formulation is
intractable, American Airlines Decision Technologies has
developed a series of operations research models. These
models effectively reduce the large problem to three much
smaller and far more manageable subproblems while still
realistically modeling the real-world situation.
Barry

Smith, Interfaces, 1992

The End

Matching Procedure
Match

criterion: 2% price range

Step 1: Match on Carrier, Date of Departure
(not return), Cabin Class, Price
Step 2: If multiple matches, match on most
restrictive advance purchase requirement met
Step 3: If still multiple, match on travel
restrictions met
Step 4: If still multiple, match on most
restrictive stay restrictions met
Yielded 36% match rate

Delta: Multiple Routes

(measured in % deviation)
Slope 0.08

-1

Fare's % Deviation
0
1

Last 7 Days

-1

-.5
0
.5
1
Load Factor's % Deviation for Day in Advance
Fare's % Deviation

Kernel Regression Fit

1.5

Pricing Practices in Airlines

1)
2)
3)
4)
5)
6)
7)

Tickets purchased in advance typically cheaper

Fares can change quickly
Saturday night stay discount
Minimum stay restrictions (e.g. overnight)
Non-refundable tickets have lower fares
Last minute deals / internet fares
One-way tickets cost more than roundtrip

Others (we dont address):

7) Frequent flyer miles
8) Bulk discounts to companies
9) Intentional Overbooking