Prof.

Prem Prakash Dewani

Indian Institute of Management Lucknow
Situation Analysis
Industry Overview

• Free Entry/Exit
Airline Deregulation • Alter Fares at will
• Hub-and-Spoke system

• Little control over fuel prices & fuel-use

Challenges efficiency
• Route Structure
• Uncertain Demand & Capacity considerations
• Special Situations

• Low Margins
Competition • Deep Discounting
• Life of fare ~2 weeks
American Airlines

Overview Marketing

• Fleet size of 468 aircrafts • Revenue Management

• 2200 daily flights • Ticketing
• 151 destinations • Frequent Flyer Program:
• 6 Hubs in United States Loyalty
• Customer Service
Satisfaction
Pricing at American Airlines

Characteristics Price Discrimination

• Demand: Independent
Business Traveler
• Inventory: Perishable but Unrestricted RT fare
$500
replenish able to some extent Personal Traveler
across Fare classes by 14 days advance purchase,
estimating the demand and refundable, Saturday night

Fare
$250 stay, RT fare
changing the authorization
Leisure Traveler
levels of buckets
60 days advance purchase,
$100 non-refundable, RT fare
• Capacity: Fixed in Short term

• Customers: Both strategic &

25 50 75
myopic
Seats
Yield Management

• The central tradeoff in yield management is between the cost

of an empty seat (the lost discounted) fare and the cost of
turning away a full-fare passenger (the difference between
the full and discount fares).
• The problem is to optimize the tradeoff by choice of bucket
size.
Revenue Management

▶Allocating resources to customers at prices that will maximize

revenue
1. Service or product can be sold in advance of consumption
2. Demand fluctuates
3. Relatively fixed resource (capacity)
4. Segmentable demand
5. Low variable costs high fixed costs
RM
Example
Room sales Demand
Curve
Potential customers exist who are
100 willing to pay more than the $15
variable cost of the room, but not
$150

Passed-up Some customers who paid $150

contribution were actually willing to pay
Total 50 more for the room
$ contribution
= (Price) x (50
rooms)
= ($150 – $15)
Money left
x (50) on the table
= $6,750
$15 $150 Price
Variable cost Price charged
of room for room
RM
Example
Room sales Demand
Curve
Total $ contribution =
100 (1st price) x 30 rooms + (2nd price) x 30 rooms =
($100 - $15) x 30 + ($200 - $15) x 30 =
$2,550 + $5,550 = $8,100

Total $ contribution =
60
(1st price) x 30 rooms + ($150 - $15) x 50
$6750 Benefit = 8100-6750=

30

$15 $100 $200 Price

Variable cost Price 1 Price 2
of room for room for room
RM
Applications
Price
Fixed Variable
Predictable Quadrant 1: Quadrant 2:
Movies Hotel
Stadium/Arenas Rooms
Duration
Function Space Airline Seats
Rental cars
Cruise Lines
Unpredictable Quadrant 3: Quadrant 4:
Restaurants Continuing Care
Golf Course Hospitals
Bucketing & Nesting

Bucketing Nesting

• Clustering the fare classes into a small number of • Nesting ensures that higher bucket seats are always
similarly valued groupings available if lower bucket seats are available
• Reduce inventory controls to a manageable number
• Minimize variability of fare class values within Protection Level = B0 – B1
buckets
B0 + 1
• Maximize the variability between buckets
B1 – B2

Austin to New York via Dallas - Full fare B1

B0
Las Vegas to New York via Dallas - Full fare
B2 – B3
B2
Austin to New York via Dallas - Moderate Discount
B1
Austin to Dallas - Full fare
B3

Austin to Dallas - Moderate Discount

B2
Austin to New York via Dallas - Deep discount
Capacity
Problem Statement
Airbus 320 = 30*6 = 180

B0 (Full price) =180=8000=180*8000 Load factor 0.35

180*0.35*8000=

0.80 B2 =80
(60*8000+40*5000+80*3000)*0.80 = B0 (Full price) =180 -120= 59
480000+200000+240000=9.2*0.8 B1 (Discounted) = 5000
B1 =121
B2 (Discounted with Restriction) = 3000
Chicago – West Coast Pricing Decision
What should be pricing strategy of American for its CHI-West Coast routes ?
Non-Stop Market
• Competition with United on the basis of fares, flight
schedules, and service quality
• Both offered $525 full coach fare and $177 highly
restricted discount fare during July-Nov 1987 on CHI-
SFO route
• United going to operate hourly flights on CHI to SFO
and LA routes from Nov 1987 onwards
Connecting Market
• United and Continental operated via a less circuitous
Denver hub.
• United and American offered comparable fares,
whereas, Continental was the low-cost fare airline.
• Continental offered $310 full coach fare and $159
unrestricted discount fare during July-Nov 1987 on CHI-
SFO route
 Chicago – West Coast Market
Load Factor of American Airlines July-Oct 1987 Passenger Trends
100.00% 350000
79% 300000
80.00% -36%

No. of Passengers
62% 250000
60.00% 71.30% AA load 200000
-33% Seasonal
55.20% factor down 150000 Demand
40.00%
-14%
by 20% 100000 24% loss
20.00% 50000
-22%
0.00% 0
July Aug Sep Oct July Aug Sep Oct

Chicago-West Coast Dallas-West Coast American United Continental

Change in Market Share July-Oct American Passenger-Fare Mix July-

1987 Oct 1987
6.00% 4.80% 100.0

4.00% Continental 80.0 91.2 90.7 87.6 87.1 AA Full

lost market
2.00%
0.40%
60.0
coach share
share despite
0.00% 40.0
rise by 4%
-2.00%
cheap fares 20.0 8.8 9.3 12.4 12.9
-1.60%
-4.00% 0.0
-3.60% July Aug Sep Oct
-6.00%
American United Continental Others Full Coach Discounted
New York – San Juan Pricing Decision
How should American respond to Eastern airlines pricing initiative ?

Competition
• American operated 9 non-stop flights from NYC - SJU
• Competition with Eastern and TWA
• Eastern periodically offered deep discounts in slow
seasons – fall and late spring.
• Eastern introduced a restricted R.T. fare of $198
midweek and $238 on weekend in Sep 1988 valid till
Dec

Customers
• Primarily local market evenly divided into 3 categories
• Business Travelers – Travel year-round
• Leisure Travelers – Peak in summer
• Personal Travelers – Passengers of Caribbean
origin with no return plans opting for O.W.
unrestricted fares
 Pricing and Yield Management

Pricing-Dilution
Share Shift
Stimulation
Displacement
American (Non Stop) United (Non Stop) Continental
(Connection)

Full Coach $ 525 $ 525 $ 310

Discounted -- -- $ 159
(Unrestricted)
Discounted (Highly $ 177 $ 177 --
Rest)
 Pricing and Yield Management

American (Non Stop) United (Non Stop) Continental

(Connection)

Full Coach $ 525 $ 525 $ 310

Discounted -- $ 179 -- $ 159
(Unrestricted)
Discounted (Highly $ 177 $ 177 --
Rest)
Pricing-Dilution $ 346 = (525-179)
D =$ (346*7684*f*d)= $ 2.66*f*d Million

f is the fraction of passengers travelling to San Francisco

d is the fraction of the passengers switch class
 Pricing and Yield Management

Exhibit 3 in the case

A Total of 59724 Flew Americans representing 26.4 %
of the total market

In Comparison, 29.4 % (11.2 % plus 18.2 %) flew

continental or other airlines (Excluding United).

This translates to 66511 passengers (59724 * (29.4/26.4)

Share shift Revenue
 Pricing and Yield Management

Putting Dilution and Share shift together

Delta R = $ (11.91 * f *s )- 2.66 * f*d million

 Net Change in Revenue as a Function of “d” and “s” in $ Million
Share Shift (s)
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
0.0
0.1
0.2
0.3
Dilutio
n 0.4
(d) 0.5
0.6
0.7
0.8
0.9
1.0
 Net Change in Revenue as a Function of “d” and “s” in $ Million
Share Shift (s)
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
0.0 0.00 1.19 2.38 3.57 4.76 5.95 7.14 8.33 9.53 10.72 11.91
0.1 -0.27 0.92 2.12 3.31 4.50 5.69 6.88 8.07 9.26 10.45 11.64
0.2 -0.53 0.66 1.85 3.04 4.23 5.42 6.61 7.80 8.99 10.18 11.37
0.3 -0.80 0.39 1.58 2.77 3.96 5.16 6.35 7.54 8.73 9.92 11.11
Dilutio
n 0.4 -1.06 0.13 1.32 2.51 3.70 4.89 6.08 7.27 8.46 9.65 10.84
(d) 0.5 -1.33 -0.14 1.05 2.24 3.43 4.62 5.81 7.01 8.20 9.39 10.58
0.6 -1.60 -0.40 0.79 1.98 3.13 4.36 5.55 6.74 7.93 9.12 10.31
0.7 -1.86 -0.67 0.52 1.71 2.90 4.09 5.28 6.47 7.66 8.85 10.05
0.8 -2.13 -0.94 0.25 1.44 2.64 3.83 5.02 6.21 7.40 8.59 9.78
0.9 -2.39 -1.20 -0.01 1.18 2.37 3.56 4.75 5.94 7.13 8.32 9.51
1.0 -2.66 -1.47 -0.28 0.91 2.10 3.29 4.49 5.68 6.87 8.06 9.25
What
Happened?
American decided to introduce a relatively-unrestricted
$179 discount fare, with a 3 day advance purchase
requirement in order to control dilution.

The possibility of exactly matching Continental’s $159 fare

was considered, but ruled out on the ground that it might
provoke a fare war; the $20 premium was intended as a
signal that American did not desire further fare reduction.
 What Happened?

The airline also added an unrestricted (but capacity-

controlled) $330 discount fare- a 20$ premium over
Continental’s full-coach fare.

American assumed in its calculations that 10% of

passengers “trading down” would do so to the $330 fare- the
other 90% choosing the $179 fare.
What Happened?

The weighted average fare = $(0.1×330 + 0.9×179) =

$194.10; the dilution cost per passenger = $(525-
194.10)
= $330.90 (346)

The net change in revenue= ∆R = $(11.91×s –

2.54×d) million
 Share Shift (s)
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
0.0 0.00 1.19 2.38 3.57 4.76 5.95 7.14 8.33 9.53 10.72 11.91
0.1 -0.25 0.94 2.13 3.32 4.51 5.70 6.89 8.08 9.27 10.46 11.65
0.2 -0.51 0.68 1.87 3.06 4.26 5.45 6.64 7.83 9.02 10.21 11.40
0.3 -0.76 0.43 1.62 2.81 4.00 5.19 6.38 7.57 8.76 9.96 11.15
Dil
0.4 -1.01 0.18 1.37 2.56 3.75 4.94 6.13 7.32 8.51 9.70 10.89
uti 0.5 -1.27 -0.08 1.11 2.30 3.49 4.69 5.88 7.07 8.26 9.45 10.64
on 0.6 -1.52 -0.33 0.86 2.05 3.24 4.43 5.62 6.81 8.00 9.19 10.38
(d) 0.7 -1.78 -0.58 0.61 1.80 2.99 4.18 5.37 6.56 7.75 8.94 10.13
0.8 -2.03 -0.84 0.35 1.54 2.73 3.92 5.12 6.31 7.50 8.69 9.88
0.9 -2.28 -1.09 -0.10 1.29 2.48 3.67 4.86 6.05 7.24 8.43 9.62
1.0 -2.54 -1.35 -0.15 1.04 2.23 3.42 4.61 5.80 6.99 8.18 9.37
What Happened?

American’s fare
changes were
implemented on
December 9, 1987,
and were matched
by United on
December 11,
1987.
• American’s performance in the Chicago-West Coast markets during three time
O & D Passenger Nov. 1-14, 1987 Jan. 9-22, 1988 Feb. 1-14, 1988
Totals
American Numbers in () are changes with respect to Nov. 1-14, 1987 levels.

Full Coach 4,224 584 (-86.2%) 665(-84.3%)

Total Number 28,343 31,958 (+12.8%) 32,725 (+15.5%)
[-16.4%] [-19.1%]
Total Revenue ($ 6,243 5,600 (-10.3%) 5,452 (-12.7%)
000s) [-11.7%] [-20.3%]
Number in [] arethecorresponding changes one year earlier.
Provided to correct for seasonality.
Market Share Nov. 1-14, 1987 Jan. 9-22, 1988 Feb. 1-14, 1988
American 32.8% 36.0% 37.2%
United 37.8% 43.3% 52.4%
Continental 11.8% 8.4% 4.0%
Others 17.6% 12.3% 6.4%
Load Factor American
Chicago-West 46.3% 51.6% (+5.3pts) 56.5% (+10.2pts)
Coast [-11.3pts] [-8.1pts]
DFW-West Coast 58.9% 63.5% (+4.6 pts) 66.1% (+7.1pts)
[-3.0 pts] [-4.3 pts]
Numbers in () are changes with respect to Nov. 1-14, 1987 levels.
Number in [] are the corresponding changes one year earlier. Provided
to correct for seasonality.
14
Conclusion
Making RM Work

1. Multiple pricing structures must be feasible

and appear logical to the customer
2. Forecasts of the use and duration of use
3. Managing changes in demand
Key Takeaways

• The concept of Hub & Spoke Model in the

airline industry

• Use of price discrimination & bucketing for

revenue maximization

• Passenger Utility function and its impact

• Evaluation of various options on the two

routes- CHG- SFO & NY-San Juan for
improving load factor & revenue
maximization
Thank You