Many people have seen the analogy comparing airline pricing with paint, but rarely are we given an insight into why the pricing is so crazy. I hope to provide a little bit of that explanation.
The Economics 101 explanation would be “supply and demand.” But S & D is too simplistic. If it were that easy, you would price airlines like paint. If you need paint, you go to the store and get some. If lots of people want paint, the price goes up. If few people want it, the price goes dow. But the manufacturer can always make more paint.
Airline pricing is far more complex. Let’s use a different analogy that explains, rather than demonstrates, the intricacies of pricing.
You are taking a class with a very unusual grading system. It’s a pass/fail class, and the only way that you can pass the class is to obtain one of the 21 beads that the professor is holding. The professor tells you that there are only two rules: You must buy a bead from him in an auction and each student may have only one bead. You look around the room and notice that there are only 20 students. Since each of the students can only have one bead, there’s no need to bid high. You can let each of the other 19 students buy a bead and still have two left to buy.
But then the professor throws a twist into the system by flushing two of the beads down the toilet. All of a sudden, the beads have become that much more valuable. Each student needs one to pass the class, but there are fewer beads than students. The bid prices are going to go much higher.
And the question is, so what? The above example seems like a simple supply and demand equation. Less supply than demand leads to higher prices. But there are other factors to take into account.
First, there’s a matter of time. Once that plane takes off, if the seat is empty, it’s worthless to the airline. Thus, the airline has every incentive to sell that seat. Advantage passenger?
Not quite. The airline has years of data, telling them what the demand for any given time will be. By adjusting the supply just a little bit, as the professor did above, it can make prices go much higher. If it prices a seat too high, it can always adjust it lower.
The airline also has another advantage: it knows why you are flying. An airline passenger who books a flight several weeks or months in advance is likely a leisure traveler. That passenger does not have to travel since, if the price is too high, they can always do something else. Those passengers are price-elastic, meaning that a small move in the price will have a large impact on the passenger’s decision to fly. On the other hand, a passenger who buys a ticket only a few days out is likely a business traveler, since business travelers often have to fly on short notice. The airline knows that that passenger has to fly, no matter what, and likely will pay any price for that ticket. That passenger is price-inelastic. The airline has all the power in that situation. In the situation with the professor, imagine that there are a couple of types of students. Some are just there for the fun of it. They don’t necessarily need to pass the class, they’re just trying to learn. But other students are taking the class for a requirement to graduate. They need to pass the class and are willing to pay more for the beads.
Airlines have sophisticated revenue management systems which tell them how to price tickets. The systems tell them everything from how those tickets sold at the same time in the previous year to how many people looked at tickets for a certain flight and chose not to go, implying that the tickets were priced too high. The computers can run all sorts of simulations and determine what even a small change in price or supply will do to demand in an attempt to maximize their revenues.
Airlines are further segmenting travelers with ancillary revenues. Ancillary revenues are any revenues that the airline generates that aren’t part of the ticket price. For instance, some airlines will sell you a very cheap ticket, but force you to pay to check a bag, choose a seat or even carry on luggage. These airlines often appeal to the most price-elastic customers who want to pay as little as possible and don’t mind passing up some amenities, such as the ability to select a seat ahead of time.
Airlines also sell tickets in various fare classes. Fare classes offer the ability to pay more or less for a ticket on the same flight. For instance, I may need a ticket that is fully refundable if something goes wrong and allows me to upgrade for free or a cheap co-payment. You may not care about those amenities. Thus, I would buy a ticket in a higher fare class. In the example below, I have show a ticket on US Airways from Boston to Charleston, SC. There are four different fare classes and each one offers different amenities. The more amenities you want, the more you will pay. In this case, the fares range from $100 to $692, a massive difference.
As a passenger, you will never know the “best” price for the ticket you want, but you should at least be aware of the factors that go into those prices.
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