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Follow Up: New And Creative Pricing Strategies From Those Wacky Airlines…

May 24th, 2010 · 17 Comments
Buyer Beware · Econ 101 · Follow Ups · Markets

I wrote last week about the wonderful world of airline baggage fees. I even put a version of it up on the Huffington Post. Little did I know that I was going to get new information on how airlines like to make their pricing confusing.

Apparently in addition to adding in separate fees for checked luggage, carry-on bags, pretzels, restrooms, breathing, etc., airlines have a bad habit of changing their prices very frequently. For example, the fare on flights between Atlanta and Las Vegas changes once every six seconds on average. Chris Elliott asks:

Why is this allowed?

If grocery store prices changed once every six seconds, people would be rioting in the streets. In fact, it’s hard to think of any other consumer product with such volatile prices. Even gas prices don’t change this frequently.

And so I wonder — who is letting this happen, again? And should it be happening?

All the free marketers out there, what say you?

If he were a reader, I would put this under reader questions. 🙂 A free-marketer might flippantly say that the changes in prices reflect changes in equilibrium due to shifts in supply and demand. (See lessons 3-5 and 7 here for a review.) Upon further inspection, however, this doesn’t seem to be a particularly compelling explanation. Let’s think about the determinants of supply and demand:

Determinants of Demand:

  • Price
  • Income
  • Prices of Related Goods
  • Tastes
  • Expectations
  • Number of Potential Buyers

Determinants of Supply:

  • Price
  • Input Prices
  • Technology
  • Expectations
  • Number of Firms

Therefore, we have 5 things under the demand heading and 4 things under the supply heading that could be making prices jump around. (5 and 4 since saying that prices make prices jump around is a little like a dog chasing its tail.) I don’t know about you, but I am having a bit of trouble convincing myself that any of these factors (or even all of them combined) move around enough to justify the once every 6 seconds price changes. (Also, from what I can tell, this is not simply a case of markets gradually moving towards equilibrium, since the price movements appear to be more random than that.) The closest I can get is to conjecture that perhaps somehow the fares are tracking the price of fuel, but even that argument is tenuous…so no, I don’t think that the price jumps are simply the forces of supply and demand at work.

Aside from the cause7 of the price changes is a potentially more relevant point- regardless of why they happen, rapidly changing prices are not really helpful in either consumer or producer decision-making. Since the price changes seem to be coming voluntarily from the airlines’ end, I will focus on the annoyance to consumers that this situation presents. Expectations of future prices are determinant of demand, as noted above. The rapidly changing prices mean that consumers can’t form reliable expectations about future prices, so it becomes more difficult to decide whether or not to buy something now. Consumers may shy away from purchasing because they don’t want to see a lower price later and feel like they’ve overpaid, or they may try to engage in the airline equivalent of market timing. The latter approach requires a time and effort investment on the part of the consumer and effectively raises the true cost of the airline ticket.

If the price changes are off-putting to and time-consuming for potential consumers, then they are unlikely to actually be profit-maximizing for the airlines, so I am a little confused as to why this is happening in the first place. On the up side, the behavior increases demand for sites like Yapta. So, unless Yapta is paying the airlines to behave in this way, I really have no good explanation. (And no, I am not enough of a conspiracy theorist to actually think that.)

I suppose my answers to the specific questions asked are “because not all consumer annoyances are deemed worthy of regulation,” “the government is allowing it to happen by not regulating,” and “I can’t decide,” respectively.

Tags: Buyer Beware · Econ 101 · Follow Ups · Markets

17 responses so far ↓

  • 1 Dave // May 24, 2010 at 3:17 pm

    When I lived in Dallas, I knew some guys who created software for a large airline headquartered near there. Basically, they have a massive set of OR equations that a bunch of Industrial Engineering Ph.D.’s from your alma mater (MIT) put together that will yield the optimum profit at any given time. So they adjust not only price, but also aircraft, terminal and crew schedules on the fly pretty much constantly, twenty four hours per day, seven days per week, based on what the equations tell them to do. It’s kind of like that crazy guy who lives on the bench in the park, who does what the voices in his head tell him what to do; only, in this case, it is a company that does what the voices coming from the computer tell it what to do.

  • 2 Justin Ross // May 24, 2010 at 3:38 pm

    Dave’s point has to be right on. Think about the enormous coordination and synchronization that takes place. Think also about how much of this process is dependent on random events (weather, volcanoes, whether or not Orland or Boston plays in the NBA championship). I would be surprised if prices were the only thing changing every 6 seconds. Remember also that they are using prices as signals, which can help them figure out all these different processes. If they kept them constant (in the same way grocery stores just let items sell out and just vary their stock accordingly), it would make it very difficult to discern where and how flights need to be adjusted.

  • 3 Dan L // May 24, 2010 at 3:55 pm

    “This data is across all flights (one way, round trip, multi-city) and seat classes.”

    In other words, in case it wasn’t obvious already, no individual fare is actually getting changed every 6 seconds. What *is* changing every six seconds is, apparently, at least one bit of information in some large data set of fare information (according to this “study.”) I’m pretty sure that this “6 second” statistic qualifies as a piece of non-information, unless someone can explain its significance.

    Yes, fares do change a lot, but certainly no more often than any normal fare-watching person already intuitively understands.

    Also, there are many logical explanations why high volatility in prices might make sense. For example, it would be perfectly logical to have a model that slowly decreases prices at fixed time intervals until a ticket gets sold, at which time the price jumps up. OR: one can think of fare-searching as similar to coupon-cutting. If you oscillate your price, then the price-sensitive fare-watchers who would refuse to buy at your high price can still buy at your low price, while price-insensitive lazy people will sometimes end up paying the high price.

  • 4 Håkan Arnoldson // May 24, 2010 at 4:04 pm

    Why would this have anything to do with supply and demand or the market equilibrium?
    There are always customers that want to pay more and likewise there are producers that would be willing to sell for less then the equilibrium.

    This sounds like the regular price-discrimination that budget airlines have been doing for years to attempt to capitalise on the consumer surplus.
    They want to fill all the seats on a plane even if they get $1 for the last seat it is a $1 profit for em.

    So how do you make that happen without selling all your tickets for $1 or upsetting all clients that paid more then $1?
    Well the easiest way would be to chance your prices all the time, customers will blame themselves for not booking early enough or being flexible enough about when to fly to get the $1 and the airline will catch the least price sensitive clients at the highest prices.

  • 5 James // May 24, 2010 at 4:06 pm

    It is important to note that the airlines are oligopolies. It is hard to imagine this happening in a competitive market.

  • 6 dWj // May 24, 2010 at 4:08 pm

    Late in the third comment, we finally hit “price discrimination”.

    I’ve heard — this was in the nineties; let’s presume it may still be true — that there is no single-price equilibrium in the market for airplane tickets; if airlines had to charge everyone the same price, they would have to charge high enough prices at any frequency of flights that enough of those seats would be empty that they would be losing money. Every strange pricing practice that they pull that seems only like it might extract more money from the less price-sensitive is a means of allowing them to sell enough tickets to price-sensitive customers to fill the planes and stay in business.

  • 7 Laura // May 24, 2010 at 4:12 pm

    The number of flights between Atlanta and Las Vegas is mind-boggling. I came up with 25 including only round trip tickets for tomorrow – and this presumably includes bookings for future dates. So I agree with Dan L, this is probably a piece of non-information. I’ve ticket-watched myself, and once you settle on dates, they don’t change too much except at the specified (7 day advance, 14 day advance etc.) times.

  • 8 John F. Opie // May 24, 2010 at 5:38 pm

    I think the explanation is actually rather simple: by having constantly changing prices with varying additional costs, market transparency is reduced, making it very difficult, if not impossible, to actually compare prices, reducing competitive pressures (while not actually reducing competition).

    Hence someone looking for the cheapest fare will be confronted by having dozens of options, and the hope of the airlines involved is that consumer will buy what they can afford, rather than finding the best price (i.e. they’ll buy the $200 round trip Chicago-Denver, rather than spend two hours realizing that they could have it for $165 instead).

    Example: we found that Ryan Air from Frankfurt (Hahn) to London (Stansted) with ground transportation + fees was actually more expensive for two persons than flying Lufthansa from Frankfurt (Main) to London (City), as the fees and service charges were added at the final booking, rather than being up front and hence transparent. That “€1 flight” ended up costing, door-to-door for an address in London, €272 round trip, while Lufthansa was €214 (and saved us 2 hours of transit as well).

    Reducing market transparency is key to ensuring that consumers fail to easily find competitors offering superior products at lower prices.

    The same thing works in the German cell phone industry (and I assume elsewhere): different companies offer such widely varying plans that it makes it virtually impossible to compare various plans without significant detective work to figure out what exactly is being covered…

  • 9 econgirl // May 24, 2010 at 7:18 pm

    Regarding the software point, I didn’t mean to imply that I thought that the prices were determined by monkeys pulling balls out of bingo cages. (TJ, if you’re reading this, I am baiting you again.) And yes, Dan L is right in that individual fares are not changing every 6 seconds…but say we hypothesize that the price changes are over 3600 flights, this would imply that the price changes for an individual flight once every 6 hours. Since flights are reasonably high-ticket items where multiple people often have to think about their choices come to a consensus, even changing prices every 6 hours is a big hassle for the consumer.

    @ Dan L: In your price-oscillating model, wouldn’t some lazy people get lucky and get the lower price? I guess it’s still better for the company than to always offer the lower price, but it’s not completely effective as a price-discrimination strategy.

    @ James: It is typical to classify the airline industry as an oligopoly, but it is important to remember that the amount of competition is not purely determined by the number of firms. Airlines complete pretty fiercely on price despite the fact that there are relatively few of them, so I’m not convinced how much this deviates from the competitive scenario.

  • 10 Steve // May 24, 2010 at 7:22 pm

    i think most of these answers miss the truth. it’s all about price discrimination. it is increasingly difficult for airlines to have enough information on their customers, especially in a world of online ticket purchasing. but by having volitile prices, buyers who are price conscious will try several times and pick a relatively low price whereas buyers who are less price conscious will go with the first price, which on average will be higher. therefore they can separate price conscious buyers from the less conscious buyers.

    thus airlines are able to extract more surplus from those with a higher willingness to pay, and also sell to customers with a low willingness to pay where the incremental cost is also low.

  • 11 Doug H. // May 24, 2010 at 8:04 pm

    Airlines a good example of a Bertrand Oligopoly (in my humble opinion). As Jodi mentioned, the airlines compete heavily on price driving it down to where it nearly equals marginal cost.

  • 12 Dan L // May 25, 2010 at 10:39 am

    @econgirl: Actually, my main point was that prices, in fact, do not change nearly as this post would lead you to believe. As Laura points out, a typical fare probably does not even change every 6 hours. I’m not interested in guessing what airlines *actually* do or why they do it. I’m just saying that it doesn’t much imagination to guess possible logical reasons for frequent price changes.

    @Steve: Um, price discrimination has already mentioned 3 times. But see above for the greater truth, which is that this whole discussion is predicated on a bit of total nonsense. (To be fair, nonsense is perfectly capable of starting interesting discussions.)

  • 13 econgirl // May 25, 2010 at 11:32 am

    Now you’re making me do math…*sigh* =P So let’s say that there were 2,472,916 changes over the ATL-LAS route from Jan 1 to May 13, which is when the article was written. That’s an average of 18,734 changes per day. If we assume that airlines offer flights available from today until a year from now (the Internet is telling me that this is roughly reasonable), then each day there are 365 days’ worth of (outgoing) flights on the books and thus about 51 changes for each day’s worth of flights each day. It’s not of the utmost relevance how many flights this is over, since the consumer is likely trying to choose among the flights offered on a given day or part of a day. So essentially I, as a traveler, am trying to choose the best option for me on a given day when there are 51 changes made to these prices each day. But even this is a little misleading…

    The 2,472,916 number is over all flights, including round-trip flights. Now, some airlines have started pricing their round-trip flights as the sum of two one-ways (eg. JetBlue), but others still have bizarre systems where the flights are bundled (and it can even be more expensive to fly in one direction than in two). I seem to recall that there was a maximum length of time span in order to be able to book a round trip ticket somewhere in the neighborhood of 28 days. (This was a long time ago, so things might be different now.) So you could argue that only 1/28th of the 51 price changes are relevant to me, since I have theoretically already decided what day I am returning, but this would only be accurate if I was only being shown round-trip fares.

    This is where my approximation breaks down, since I don’t know what fraction of the daily price changes for a given day’s worth of outgoing flights are actually relevant for the consumer. I could be conservative and use the 1/28 figure, and this would tell me that there are about 2 price changes per day on my flights of interest. So yeah, it’s not once every 6 seconds, but even my number seems pretty irritating from a planning perspective.

  • 14 Dan L // May 25, 2010 at 1:34 pm

    But the post was primarily about the frequency with which individual airlines change their fares.

  • 15 steve // May 25, 2010 at 5:53 pm

    @Dan L

    yes I realise price discrimination had been said before me. I was simply stating my opinion that this was the main explanation and other explanations kind of missed the boat. I then explained it further as being a way to price discriminate even though the modern market has made it more difficult since airlines increasingly know less about each specific customer.

    further the other explanations are not explanations in themselves, but really they seem to be things that enable price discrimination of this sort to occur. i.e. if the incremental price of the last seat on the plane was actually the average cost then this type of price discrimination would not occur.

    and I don’t think the discussion of how often it changes is particularly relevant. what might be more relevant and interesting would be the overall trend of prices for a single plane over time. it will show a strategy that maximises revenue given limited information about customers and perhaps demand.

  • 16 Greg // May 25, 2010 at 8:05 pm

    Hayek might remind us that competition is a discovery procedure and that the marvel of the price mechanism is the underlying order that allows for agents to use changing prices as signal to use their own knowledge for their own aims in the absence of coercion.

    Since no one can possess much of the knowledge – of a market, for example, Hayek might argue that rapidly changing prices are valuable in speeding the signals that prices embody.

    In the absence of coercion, if prices are changing so quickly – and presumably these prices are fluctuating, that is they are not moving in a constant direction – could a potential buyer of airline services merely wait – 6, 12, even 120 second for a preferred price?

  • 17 Mr. Econotarian // May 27, 2010 at 9:13 pm

    Price discrimination allows airlines to offer more flights.

    Imagine the arline’s cost of a flight was $1000. At a price of $1500, they end up only selling out one flight, and making $500 profit. So they sell out that flight.

    Then they offer a second flight at $1200, and manage to get enough other people who didn’t want to buy the $1500 flight but are OK for the $1200 flight to sell out the second flight. Now we have 2 flights and $700 profit.

    So yes, price discrimination does soak up consumer surplus, but with the benefit of raising amount sold and allowing more people to purchase goods.

    Price discrimination goes on every day at car dealerships, Ebay, ticket resellers, the global price differentials of prescription drugs, etc.

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