In my ECONS101 class last week, we covered price discrimination: where a firm charges different prices to different groups of consumers for the same good or service (and where the difference in prices does not arise from a difference in cost). Price discrimination comes in three forms: (1) first-degree price discrimination (or personalised pricing), which involves setting a different price for every consumer; (2) second-degree price discrimination, which involves the consumer paying a declining price for each additional unit that is purchased; and (3) third-degree price discrimination (or group pricing), which involves setting different prices for known groups of consumers.
Airlines typically engage in price discrimination (as I discussed here), in the form of group pricing. Specifically, they engage in a type of group pricing known as menu pricing. As I noted in this post:
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.
Menu pricing is an imperfect form of price discrimination. The ultimate form of price discrimination would be for a firm to sell to every consumer for exactly the maximum that they are willing to pay. This is a perfect form of personalised pricing (first-degree price discrimination). However, this is difficult for firms to achieve in practice, as consumers don't typically volunteer information on how much they are willing to pay. Nevertheless, firms would still really like to do this, and so estimating consumers' willingness-to-pay is important to firms. If they can achieve that, then the next step is to charge every consumer a different price.
And that brings me to this article in The Verge last month:
Delta Air Lines is leaning into dynamic ticket pricing that uses artificial intelligence to individually determine the highest fee you’d willingly pay for flights, according to comments Fortune spotted in the company’s latest earnings call. Following a limited test of the technology last year, Delta is planning to shift away from static ticket prices entirely after seeing “amazingly favorable” results.
“We will have a price that’s available on that flight, on that time, to you, the individual,” Delta president Glen Hauenstein told investors in November, having started to test the technology on 1 percent of its ticket prices. Delta currently uses AI to influence 3 percent of its ticket prices, according to last week’s earnings call, and is aiming to increase that to 20 percent by the end of this year. “We’re in a heavy testing phase,” said Hauenstein. “We like what we see. We like it a lot, and we’re continuing to roll it out.”
Obviously, Delta thinks that it has enough information about its customers to make this work. It was inevitable that firms would eventually start using artificial intelligence and machine learning to estimate the maximum willingness-to-pay for each of their consumers. This is likely to be just the beginning of a wider trend, given the potential for greater profits for firms. As I note in my ECONS101 class, there is no possible pricing strategy that could be more profitable than perfect personalised pricing. Delta's approach probably isn't perfect, but it is likely to be more profitable than the regular airline group pricing strategy.
[HT: Marginal Revolution]
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