Economics-Price Discrimination in the Airline Industry - Case Study Example

Topic: Economics-Price discrimination in the airline industry (ORBITZ) as the main example Internet technology has changed the way of doing business in both B2B and B2C transactions. The new business scenario has impacted the transparency of markets positively for the benefit of consumers as well as businesses. It has led to changes in industrial organizations’ market transparency. Airline industry and its segment Online Travel Agencies (OTA) have exhibited increased transparency level in B2B and B2C transactions. Orbitz – an OTA has risen to the occasion to reap the benefits of doing business via internet. Price discrimination has been made possible only through internet because airline companies have been able to cut operational costs, which formed 3% to 25% share of doing business through booking agents and other means of selling tickets. By market transparency, information on product and pricing is made available to online travel companies, like Orbitz, which employ new techniques to differentiate prices by yield management, market concentration, and shift in consumer demand as a result of market transparency besides time, flexibility, different prices for same flight and such other price discrimination techniques. Airline firms apply different approaches to increase their revenues by correlating pricing decisions to the standard of transparency offered by marketing mechanism of internet technology – a significant tool of organizational strategy. Statement of the question According to Stavins J, in a perfect competition scenario, firms cannot discriminate price but it is possible in a monopolistic market. A monopolist, according to economic theory, can practice pricing strategies if information on consumer preferences is available and the transaction cost of deciding more than one price is not an issue. In actual markets, these extreme don’t work; real life market is neither perfectly competitive nor monopolistic, it lies somewhere in between the two footpaths of the road. The big question arises – how does market react? Does price discrimination increase or decrease with the increase in competition. It can be derived from the above statement that with the increase in market concentration, price discrimination also increases. Although theory states otherwise but Borenstein (1985), Holmes (1989), and Gale (1993) have predicted increase in price discrimination with the increase in market competition (Stavins 1). In airline industry, whether higher market concentration increases or decrease price discrimination, can be tested through empirical analysis although it is hardly available. Some analysts have tested the price discrimination mechanisms used by airlines. According to Borenstein and others (1992), average price level increases with an increase in market concentration. Studies reveal that there is negative effect of market concentration on price (Stavins 3). Difference in ticket prices on the same flight has been a matter of public discussion through consumer groups and media. The authenticity of charging different rates on the same flight has been questioned. But it can be given a clean chit due to cost based imbalances or demand-based differences. Airlines discriminate price in two ways. First, they offer various packages or combo of fares and limitations related to tickets, and secondly, through limiting the number of discounted seats on each journey. First is a type of self-selection price discrimination. It depends on customers’ choice to opt for particular features of a product – a seat. In the second alternative, airlines use rationing as a tool to decrease the quantity of cheaper item. In the case of airline seats, economy class seats are cheaper and limited. Consumers can’t avail discounted seats because of limitations. Airlines divide consumers as price sensitive with comparatively reduced disutility from travel limitations and price inelastic consumers with increased disutility on ticket restrictions. The purpose of Saturday-night stay-over and advance –purchase of tickets is to prevent price-inelastic consumers from purchasing low-fare tickets on a flight. This paper discusses new techniques to differentiate prices by yield management, market concentration, and shift in consumer demand as a result of market transparency, time, flexibility, different prices for same flight and such other price discrimination techniques (Stavins 4). Literature Review As transparency of airline market has added a new dimension to airlines’ price discrimination methodologies in B2C transactions, the available information facilitates a consumer to finalize a product price at lower than market value. It can happen if search costs are reduced to derive lower market price. This assumption is backed in many research papers in the recent literature. According to Furstenberg (2001), greater transparency in a principal-agent mostly creates losses for the principal. Wise and Morrison (2000) opine that although the Internet has made higher liquidity and transparency a possibility, sellers are not willing to participate due to the risk of price pressures. Similarly, Zhu (2002) suggests that transparent electronic scenarios are decisive to large, high cost suppliers in a B2B exchange (Granados 20). In B2C markets, taking the example of OTA like Orbitz, some retailers charge low prices to attract informed consumers, while others charge high prices to uninformed consumers (Brynjolfsson and Smith, 2000). Sinha (2000) is of the opinion that the Internet offers the choice to consumers to verify sellers’ costs, which allows them to bargain and settle or stand firm on lower bids, resulting in decreased market prices. An increase in market transparency may affect price elasticity of demand, impacting consumer valuation of a buying in different ways; it may increase the value of a product or reduce its search costs. Value on deal may increase because of better alternatives. The resulting increase in consumer surplus may bring mixed effects of market transparency as well (Granados 20). Orbitz – a case study Orbitz.com came into existence on June 4, 2001. In airline and OTA industry, Orbitz provides booking capabilities for airline tickets, rental cars, hotel and vacation packages, and related travel and hospitality products. Orbitz was a reaction of major airline companies, American, Continental, Delta, Northwest and United, a “reintermediation” in order to counterweight the airlines’ share of the market for intermediation services on the Internet (Stavins 1996). Being a leading online travel company, it provides its customers a line of travel products like airline tickets, lodging, car rentals, cruises and vacation packages. The company gets a good chunk of its revenue from the following sources: Supplier transaction fees: It receive minimum transaction fees based upon contractual arrangements from its charter associates. Market based commissions from non-charter suppliers, who currently pay commission to online travel agents, are a resource of revenue generation. Consumer service fee: Consumers pay a $5.00 per ticket (maximum $10.00 per reservation) service fee on air transactions and other fees in certain cases. Reservation system booking incentives: Orbitz gets booking incentives under its contract with Worldspan for air and car rental ticket reservations and lodging reservations clicked through their system and shares with its charter associates a part of the booking incentives related to travel products booked with that charter associate. Sales of advertisements on website: Through delivery of third-party advertisements on Orbitz website, advertising revenues are derived (ORBZ Securities Registration Statement (S-1/A) (2002-07-03). Charter Associate Agreements Orbitz has signed charter associate agreements with 42 airlines, including its Founding Airlines, five of the largest U.S. lodging companies and seven major car rental companies. The charter associate agreements with Founding Airlines would be non-existent by July 2007, and agreements with other suppliers will expire with-in one to two years. These agreements provide Orbitz with access to all fares and rates generally available to the public, including rates and fares available on the suppliers website. Besides, charter associates also provide total in-kind marketing support under contract valued at $14 million annually under the terms of charter associate agreements, based on anticipated bookings and the charter associate agreements currently in effect. It could be any thing like references to Orbitz in company brochures and in suppliers’ fare sale advertising, free tickets for promotional use and access to discounted Web-only fares and rates (ORBZ Securities Registration Statement (S-1/A) (2002-07-03). Finally, these charter associate agreements provide Orbitz with minimum guaranteed transaction fees that go on decreasing regularly through the time of the charter associate agreement. In return, Orbitz guarantees impartial display of fares and rates of all suppliers, not accepting overrides from distinct suppliers for offering wanted placements in displays appearing from search requests (ORBZ Securities Registration Statement (S-1/A) (2002-07-03). Orbitz two technology initiatives -- supplier link technology and Booking Engine Services are a part of air revenues. The supplier link technology has enabled Orbitz to establish direct connection with an airlines internal reservation system, facilitating Orbitz to let go GDSs for a part of Orbitz airline ticket bookings. This initiative has reduced distribution costs for airlines and increased Orbitz profits. Booking engine has enabled bookings on outsourced basis for some airline suppliers like American Airlines, facilitating of tickets’ booking via American Airlines website, processed through Orbitz booking technology. Such contracts have been made with airlines also (ORBZ Securities Registration Statement (S-1/A) (2002-07-03). Discussion of the research method used According to Joanna Stavins report, increase in online ticket sale has been the reason behind the low cost of airlines’ tickets. Orbitz has been the fastest rising distributor, founded by five of the biggest US airlines – American Airlines, Continental, Delta, Northwest and United (Devlin, 2002). Orbitz is giving good competition to Travelocity and Expedia – the other distributors for number one slot (1996). In the airlines industry, Online travel agency (OTA) sector is quite transparent about the information on the product and price and OTA firms like Orbitz practice different approaches to increase profit by matching pricing decisions to the standard of transparency offered by the market mechanism, a known tool of organizational strategy (Granados, 2003). Table 1. Relative Levels of Market Transparency for Online Travel Agencies (OTAs) The above table classifies the airlines industry into four categories. Orbitz belongs to OTA TYPE – Airline consortium and its price transparency and product transparency is high, serving multiple airlines, itineraries, and fares. Either price transparency or product transparency or both could provide reliable basis to support market exchange in airline tickets, depending on the airline firm’s strategy (Granados et al. 13). B2C markets and Internet best sellers, dealing in products with digital features attract more consumers by using dynamic market microstructures. It creates a positive relationship between consumer demand and market transparency. Consumer demand behaves in proportion to the level of product transparency. Orbitz and Hotwire exhibit this scenario in OTA industry. Orbitz market mechanism for airline tickets, after receiving a booking information request by a customer, offers multiple travel options, planned with the lowest ticket prices and minimum stopovers first. Due to Orbitz comparatively better transparency market mechanism, demand of tickets on Orbitz is greater than Hotwire. It is observed that price elasticity of consumer demand is same, irrespective of the site. Assuming it to be perfect competition market, where there are only two sellers, consumer demand can be shown by a linear demand function of lower transparency leading to downward shift in the demand curve (Granados et al. 17). Figure1. Impact of Market Transparency: Shift in Consumer Demand It (The Market Share and Price Ratio Equivalence Proposition) suggests that if two sellers price a product at various levels of market transparency to increase profit, their market share ratio will be equal to price ratio. In the airline industry, airlines require stable route scheduling, which becomes the basis for fixed supply with low marginal costs, so short and medium term pricing decisions are aimed towards increase in profit (Granados et al. 17). In scenario second, if the market transparency increases, impacting on product and price discovery process, it affects consumer surplus in three ways. Value on deal increases when there are better alternatives. Secondly, more product alternatives are generated. For example, via internet, OTAs like Orbitz provide instant and cheap access to tables with multiple choices of air-carriers, flight itineraries and ticket prices. By booking a ticket through Orbitz, a consumer can check other options and behave like one’s own travel agent, purchasing a domestic roundtrip ticket between big cities. Third, information availability may also result in bargaining by consumer at a lower price for a ticket (Granados et al. 19). Figure 2. Impact of Market Transparency: Shift in Price Elasticity of Demand There could be another possibility of mixed effects of market transparency, which can be explained by comparing Orbitz and Priceline. As Priceline targets such customers that are less interested about product features and its market transparency is lower in comparison to Orbitz, it may affect consumers two ways. First, consumers may browse only Orbitz site because of higher transparency and avoid Priceline. It may be a possibility that both firms have same set of customers, who check both sites for lower fares. To increase profit, Priceline must lower the ticket prices to the level where its price ratio is equal to the square of the market share ratio. If a price ratio is found to be higher in the market than the square of the market share, then Orbitz can decrease prices to increase revenue (Granados et al. 23). Figure 3. Impact of Market Transparency: Mixed Effects Differentiating prices, a type of price discrimination to provide air services at varied prices, is used to at the same time in different segments. Pricing of tickets depend on the days left before departure, the current booked load factor, the calculation of total demand by price point, applicable competitive prices and changes by the day of the week of boarding and time of day. Seats are divided into different classes such as first class, business class and economy class for pricing them differently (Airline: Ticket Revenue, 2007). Yield management is a type of price discrimination that makes airlines’ profits soaring high through economic efficiencies. Companies like Orbitz, doing business via internet have unlimited opportunities to discriminate price. Orbitz has collected a wealth of customer data to manipulate customers by identifying the value each buyer decides on a product or service offered. Higher the value attached by a customer to a product, charged rate increases accordingly ( Sakalosky Mark 2003). Price discrimination is the sole purpose of differential pricing. Taking the example of Continental Airlines for advance purchase round trip tickets, following prices are offered from the company’s website. {From Minneapolis to Newark, NJ on Wednesday, March 20, returning Friday, March 22: $772.50 {From Minneapolis to Newark, NJ on Wednesday, March 20, returning Wednesday, March 27: $226.50 {From Newark, NJ to Minneapolis on Friday, March 22, returning on Wednesday, March 27: $246.50 (Odlyzko 7). Purchasing the second and third tickets and using the first half of each could have saved around 40% compared to the cost of first ticket. It happens due to the desire to earn more from business travelers who make short mid-week journeys. The conditions of the Continental contract could have been violated if second and third tickets had been purchased. But airline can not force the contract conditions as tickets might have been purchased through different names, without using credit card and not providing frequent flyer information while purchasing them. It shows that by maintaining privacy, price discrimination becomes more intensive. Price discrimination can be concealed by airlines by avoiding simple cash pricing; a combination of cash and frequent flyer miles can be offered as a customized offer based on the passenger’s past dealings with the airline (Odlyzko 8). Another important factor affecting price discrimination is market concentration on a route; higher the concentration, effect of restrictions on airfare will be lower. The effect of Saturday night stay-over ticket restriction on airfare calculated at the 25th, 50th, and 75th percentiles of HHI for the sample at the mean value of market share is given in the table below. The assumption becomes applicable that operation of more carriers on a given route increases competition for air passengers, whose demand is elastic but business consumers with inelastic demand are charged higher airfare, making cost effect constant. The end result is that on routes with more competition and lower market concentration, there is higher price discrimination (Stavins 12). In advance purchase of airline ticket, result is also same. The table below shows the average effect on airfare of extending an advance purchase requirement by one day, measured at the 25th, 50th, and 75th percentiles of HHI for the sample at the mean value of market share (Stavins 13). Whether it is Saturday-night stay-over requirement or Advance purchase need, the general perception is that in the age of information technology and internet, there will be more price discrimination. Sellers would indulge in differential pricing but this is a dangerous tendency and there is resentment in common man on such practices. Government policy is also ambiguous because of welfare benefits arising out of price discrimination. But rules must be prescribed to use private information. As long as there are economic benefits of price discrimination, it is going to stay in all industries (Odlyzko Andrew 15). Works Cited “Airline: Ticket revenue.” Wikipedia. 2007. 19 April. 2007 . Granados, Gupta & Kauffman. “Can you see what I see? Transparency, consumer demand and strategic pricing in B2C electronic commerce.” 2003. 19 April. 2007. Odlyzko Andrew. “Privacy, Economics, and Price Discrimination on the Internet.” 2003. 19 April. 2007. . “Orbitz.” Wikipedia. 19 April. 2007. . “ORBZ Securities Registration Statement (S-1/A) (2002-07-03).” 2006. 19 April. 2007. . Sakalosky Mark. “Price discrimination: Analyzing customer data.” 2003. 19 April. 2007. . Stavins Joanna. “Price discrimination in the airline market: the effect of market concentration.” Federal Reserve Bank of Boston. 2007. 19 April. 2007. . Read More