Price discrimination and airline tickets

Earlier this month, Rob Nicholls (UNSW) wrote an article on The Conversation about airline ticket prices:

Few things are more annoying than spending a large sum of money on a purchase, only to discover that someone else got the same thing for a lower price. This often happens with airfares. You go the same website, search the same airline, choose the same seat row and fare conditions, but you’re offered a different price depending on when and where you do it. Why?

Often it’s a result of price discrimination. This happens when a seller charges you what you’re willing to pay. Of course, it also needs to be at a level that the seller is willing to accept.

When it comes to airfares, there are two levels of price discrimination, both driven by algorithms. First, there is price discrimination by the airline. Airline pricing is typically dynamic. That is, the prices are higher for more popular flights. Then there are intermediary platforms, such as travel agents or price comparison websites, which can introduce a further level of price discrimination.

Nicholls' article is interesting, but it misses some important points about the price discrimination undertaken by airlines, and so it is worth also considering those points. First, price discrimination only occurs when the seller is selling the same product to different consumers for different prices, and where those differences in prices don't reflect differences in cost. So, the difference in price between premium economy airline tickets and economy airline tickets is not price discrimination, because there are differences in cost between those ticket classes.

Second, perfect price discrimination (first degree price discrimination, or personalised pricing) is when a seller charges you exactly what you're willing to pay. However, sellers typically don't know what you're willing to pay (you might not even know what you're willing to pay), so most sellers engage in some form of imperfect price discrimination.

In contrast, third degree price discrimination (group pricing) occurs when the sellers charges different prices to different known groups of consumers. This is the type of price discrimination that movie theatres engage in, when they sell the same tickets to students or seniors for a lower price than general admission. This isn't the type of price discrimination that airlines engage in.

Airlines typically engage in second degree price discrimination. This is where the sellers doesn't know the willingness to pay of the consumer, and doesn't know what group they belong to, but they can infer from the consumer's choices how much they are willing to pay. One type of second degree price discrimination is menu pricing. It's called menu pricing, because it is the type of pricing that restaurants use. The seller offers a menu of different options, and knows which options will appeal to consumers with relatively inelastic demand (where the mark-up should be higher), and other options will appeal to consumers with relative elastic demand (where the mark-up should be lower).

Airlines don't quite have a menu. However, they do offer a range of options to consumers. Some consumers will buy a ticket close to the date of the flight, while others buy far in advance. That is information the airline can use. If you are buying close to the date of the flight, the airline can assume that you really want to go to that destination on that date, and that few alternatives will satisfy you (maybe you really need to go to Canberra for a meeting that day, or to Christchurch for your aunt's funeral). Your demand will be relatively inelastic, so the airline can increase the mark-up on the ticket price. In contrast, if you buy a long time in advance, you probably have more choice over where you are going, and when. Your demand will be relatively elastic, so the airline will lower the mark-up on the ticket price. This intertemporal price discrimination is why airline ticket prices are low if you buy far in advance.

Similarly, if you buy a return ticket that stretches over a weekend, or a flight that leaves at 10am rather than 6:30am, you are more likely to be a leisure traveller (relatively more elastic demand) than a business traveller (relatively more inelastic demand), and will probably pay a lower price.

The outcome, as Nicholls notes, is that you are unlikely to be paying the same ticket price as the person seated next to you on the plane. The ticket price you paid will be based on the airline's assessment of your willingness to pay, based on the choices you have made.