Price Discrimination in the Airline Industry: the Effect of Market Concentration - Term Paper Example

PRICE DISCRIMINATION IN THE AIRLINE INDUSTRY: The Effect of Market Concentration Contents 1. Introduction………………………………………………………………………..2 2. Theoretical Discussion…………………………………………………………….3 3. Key Data and Statistics……………………………………………………………7 4. Analysis……………………………………………………………………………9 5. Conclusion……………………………………………………………………….10 References………………………………………………………………………..11 List of Figures……………………………………………………………………12 1. Introduction Since liberalization, the airline industry in the United States have undergone significant transformation in terms of competition and hence pricing, owing to the wide range of legislations and regulations such as open skies and other similar policies that encouraged competition. Such change have led to a serious makeover of the market structure in the airline industry ultimately translating into rise in competition and a simultaneous shift in the firm’s ability to adopt discriminatory pricing strategies and models. There have been varying opinions about the impact of market concentration on pricing strategies adopted by the firms operating in the airline industry. On one hand, certain theorists use the ceteris paribus clause to explain the phenomenon, claiming that increased market concentration leads to increased instances of price discrimination since the sheer presence of a large number of firms operating in the industry gives immense power in the hands of such firms to implement discriminatory pricing models. While on the other hand, researchers like Borenstein (1985)1 claim that there exists a negative relationship between market concentration and price differentiation, i.e., price discrimination increases as the market competition intensifies e.g., when the market structure undergoes changes from monopoly to imperfect competition. This paper seeks to investigate, analyze and discuss the various aspects related to price fluctuations in airline industry with regard to market concentration and establishes a relationship between price discrimination and market concentration through a series of theoretical discussions, and analysis of data and other statistics presented in this paper. 2. Theoretical Discussion Theoretical analysis carried out by researchers in the recent times, to study the relationship between market concentration and price discrimination, point to the fact that imperfect competition fuels the likelihood of such a wide difference in pricing among firms. Studies show that as a market undergoes transition from monopolistic market structure towards imperfect competition it has a significant impact on the pricing as well. This happens since prices are highly sensitive towards the form of market and hence more intense the competition, wider the gaps between pricing. In case of monopolistic market structure, the consumers are heterogeneous and hence the firms must segment their markets accordingly in order to cater to their target customers in a better manner. However, as the competition increases, the consumer preferences begin to differ as well. The consumers in a monopolistic market condition differ not only in terms of their tastes and preferences related to a particular product but also differ widely in terms of brand preferences2. In another similar study carried out by Borenstein and Rose3, it was established that there exist a negative relationship between market concentration and price discrimination. This claim was based on the study that showed that the prices varied in accordance with the routes which were dominated by high competition. Also, the study established firm evidence that, the firms in an imperfect competition determine their pricing strategies by manipulating the brand preference of heterogeneous customers as opposed to taking advantage of the heterogeneity that exists among them in terms of airline reservation prices. For instance, business class passengers exhibited strong brand loyalty as compared to passengers belonging to economy class. Also, leisure travelers were more concerned about the lower airfares and hence had the least brand loyalty. The empirical study carried out by the researchers which involved a series of cross sectional regressions on varying degrees of prices on a particular measure of market concentration as well as a host of other independent variables, helped in asserting the fact that increase in route concentration led to a simultaneous rise in average prices. The studies thus conducted, further demonstrated that in a non monopolistic market place, price discrimination is not restricted to highly concentrated market structures. Borenstein (1985) claimed that the heterogeneity of consumers is based not only on their preference for a particular brand but also on their willingness and ability to pay for a particular product or service. The occurrence of price discrimination can be avoided if the firms operating in the industry breakdown their target markets by categorizing their target customers into various segments based on various factors such as their ability and willingness to pay for a product or service. This would help in creating adequate barriers to entry and hence control the competition within the industry. Borenstein, in his study, further claims that: "….when a usable sorting mechanism exists; a firm could be forced to discriminate to avoid losses when competing with other discriminating firms"4. He presented a comparison of consumers sorted in accordance with their respective reservation prices i.e., the traditional concept of price discrimination, with that based on their preference for a particular brand/s. This showed that the two distinct strategies of price discrimination, i.e., one based on airfares and the other based on strong preferences for a brand; had varying effects on sales equilibrium, as well as the number of firms present in the industry. Further studies conducted in this behalf by Gale (1993), who developed theoretical models of price discrimination in the airline industry, showing the impact of market structure on price differentiation. This theoretical model offered a relatively different perspective, which stated that in equilibrium, the price differentiation in terms of advance purchase fares and unrestricted fares in a non cooperative duopolistic market structure is greater as compared to that observed in terms of equilibrium in monopolistic market conditions5. Stavins (1996)6 also asserts the negative relationship between price discrimination and market concentration. The study conducted by her was based on a novel perspective that included data collected from the Official Airline Guide, whereby she proposed consideration of other factors such as the time of purchase of the airline ticket (which varied from 2 to 35 days) and other similar characteristics related to booking of the ticket. Her study mainly concentrated on four key aspects i.e., requirements related to advance purchase of air tickets, penalties resulting from cancellation, requirements related to Saturday night stay overs and other similar unrecognized restrictions. The major findings of the study conducted by her resulted in the following conclusions: there is a negative relationship between the ticket prices and ticket restrictions related to Saturday night stay over and advance purchase requirements; assuming the market share variable to be constant, on a particular route, price discrimination is found to be relatively lower in highly concentrated markets. The American airline industry underwent tremendous change during the turn of the century owing to various factors such as the changing gas prices, increase in cost of travel, change in competition, change in demand and cost structure etc. The change in oil prices triggered off a series of events beginning with a sharp rise in the airlines' input costs. The condition of the industry worsened with introduction of information technology, terrorist attacks (September 11) and the ongoing economic crisis. As a result, several huge and traditional American carriers were pushed towards extreme economic losses resulting in bankruptcy. The other major players revised their cost structures in order to retain their competitive positioning which led to implementation of differing pricing strategies. Thus it can be safely presumed that the sudden change in market structure led to an increase in competition and hence affected the pricing leading to wide scale differences in airfares across various firms operating in the industry. 3. Key Data and Statistics In order to sustain their competitive positioning in a highly concentrated market, they seek to establish a sorting mechanism with which it can differentiate its target customers on the basis of their preferred brands. Product delivery strategies such as Frequent Flier Programs, is one such method that the airlines could implement in order to segment their market. Such programs can prove to be beneficial for business class passengers who have a high frequency of travelling as compared to the leisure travelers. Rewards in terms of discounts and other similar benefits could be offered to such frequent travelers in order to increase and improve brand loyalty among the target customers. Such differences in pricing strategies further fuel the price discrimination in a highly concentrated market since the customers belonging to a particular segment are offered differential treatment in terms of benefits, perks and airfares as opposed to the other group of travelers i.e., those who travel for leisure. The implementations of such discriminatory pricing models whereby the firms tend to exploit the heterogeneous brand preferences of its target segment in turn encourage price discriminatory practices. Hence, it could further be claimed that price discrimination is more rampant in markets with high number of business travelers and firms offering services in this industry have greater power to differentiate themselves on the basis of price. Furthermore, if the consumers are heterogeneous in terms of routes frequently used by them and are difficult to categorize into specific segments then the airlines would find it difficult to differentiate on the basis of prices and hence would lead to a reduction in implementation of such discriminatory pricing policies. Flight Details: JFK Airport, New York to LAX Airport, Los Angeles, California7. 2 days Advance booking Northwest Airlines Delta Airlines Flight Duration Air Fare (US$) Flight Miles Flight Duration Air Fare (US$) Flight Miles Single Trip (per adult person) 10 H, 22 M 385.80 2566 6H, 20 M 459.60 2472 Round Trip (per adult person) 7H, 31 M 569.40 1258 8H, 18M 569.40 2576 One month Advance booking Single Trip (per adult person) 7H, 02M 143.20 2560 6H, 16M 139.60 2472 Round Trip (per adult person) 7H, 55M 285.30 2580 6H, 24M 279.20 2472 4. Analysis On the basis of the theoretical discussions based on empirical data mentioned above, it could be claimed that price discrimination occurs mainly on account of two key factors namely - brand preference and ticket prices. Thus where the market structure is highly monopolistic in nature, the degree of competition has a direct impact on the ability of the airlines in the industry, to maintain marginal costs. Hence the firms operating in such an industry experience great power in dictating their independent pricing policies and maintain control over the market. However, in order to retain its customer base, the firms have to adopt marginal pricing strategies. In this type of market structure, as the competition increases the price discrimination increases as well. Hence, if the customers display higher brand loyalty and purchase air tickets at higher fares e.g., business travelers, owing to low elasticity of demand for air travel, as compared to those who purchase air tickets at relatively lower air fares e.g., leisure travelers then the increase in market competition would lead to a sharp fall in markups in the lower portion of price distribution as opposed to the higher one. Price discrimination studies have historically focused on studying the impact of discriminatory pricing policies particularly in monopolistic market structures. However, a detailed study of the phenomenon suggests that such practices are in widely in existence in competitive environments. Studies have sought to establish a relationship between pricing and market concentration which suggest that as opposed to monopolistic market conditions, consumers in an oligopolistic market or a market with high concentration of firms in an industry, the relationship between pricing and competition differs widely, since the customers' choice and preferences vary accordingly. Thus, when firms try to manipulate prices in accordance with a particular target segment, all the other equilibrium prices in the industry can be adjusted accordingly - a privilege which is absent in a monopolistic market structure. 5. Conclusion The present recognition of deregulatory policies and marketization of public utility services is dependent on the notion that introduction of new profit driven inducements and supply systems would augment effectiveness, intensify implementation of revolutionary measures, which will ultimately lead to price control and hence prove to be beneficial to all classes of customers irrespective of the market segment they belong to. On the basis of the empirical findings discussed above, it can be safely presumed that price dispersion occurs on account of attrition in a firm’s ability to implement discriminatory pricing strategies. The benefits enjoyed by the consumers in any industry depend on several factors such as privatization, and deregulation policies as well as the type of relationship that exists between product pricing and competition. The studies presented in the above sections determine, that firms in airline industry are better equipped to implement discriminatory models of pricing in highly concentrated markets, and the type of policies adopted and practices followed by such firms would determine the probable entry barriers which in turn would lead to narrowing of the gaps that exist between prices charged to different customers belonging to different market segments. References: Borenstein, S., (1985). Hubs and High Fares: Dominance and Market Power in the U.S. Airline Industry. The RAND Journal of Economics, Vol. 20, No. 3, Pp. 344 – 365 Borenstein, S., (1985). Price Discrimination in Free-Entry Markets. The RAND Journal of Economics, 16(3), Pp. 381 Borenstein, S., Rose, N., (1994). Competition and Price Dispersion in the U.S. Airline Industry. The Journal of Political Economy, Vol. 4, No. 102, Pp. 653 – 683 Gale, I., (1993). Price Dispersion in a Market with Advance - Purchases, Review of Industrial Organization, Vol. 9, Pp. 451 - 464 Holmes, K., Ross, B., (1989). Is Airline Price Dispersion the Result of Careful Planning or Competitive Forces?, Review of Industrial Organization, Vol. 13, Pp. 523 - 541 Stavins, J., (1996). Price Discrimination in the Airline Market: The Effect of Market Concentration, Review of Economics and Statistics, Pp. 200 – 202 Northwest Airlines (2009). Flight Search, viewed: March 23, 2009 from: List of Figures: Figure 1: Route by market structure Figure 2: Distribution of Tickets and Route by Market Structure and Flying Distance (Source: Borenstein, S., Rose, N. L., 1994 Competition and Price Dispersion in the U.S. Airline Industry, Journal of Political Economy, Vol. 102, No. 4) Read More