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Second-Degree Price Discrimination and Intergroup Externalities in Airline Routes Between European Cities
Abstract
This paper presents a model of second-degree price discrimination and intergroup effects. Consumer heterogeneity is assumed on both a horizontal and a vertical dimension, while various distinct market structures, some of which include low-cost carriers (LCCs), are considered. We theoretically show that the rivalry among full-service carriers (FSCs) usually reduces the distance between business and leisure fares. The rivalry with an LCC increases this distance causing a reduction of leisure fares and, possibly, an increase of business fares. We test these implications using data concerning the early stage of low-cost entry in Italy on European routes. The empirical results largely support our theoretical findings.
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This paper reports the findings of an empirical study of low cost airlines. The investigation
centers upon low cost strategies and organization structure of three airlines in the United States over a four year period. Results show that such strategic combinations are very influential on the entire market, resulting in increased sales for all carriers and a decrease in the average fare sold. Of particular note is the role that structure plays in low cost airlines that enables success as they continue growing and competing in new geographic markets.
This paper conceptualizes various discount strategies used by airlines. Using a constrained revenue maximization model that assumes interdependent demand, it develops rules to guide decision-making, and shows that the large fare discount-many discount seats and small fare discount-few discount seats strategies are optimal. Empirical support is provided for the large fare discount-many discount seats, the no fare discount-moderate discount seats and small fare premium-few discount seats strategies. In addition it identifies the large fare premium-very few discount seats strategies. We argue that these strategies are used in various demand situations and allow airlines to price discriminate.
We draw attention to two problems associated with the use of instrumental variables (IV), the importance of which for empirical work has not been fully appreciated. First, the use of instruments that explain little of the variation in the endogenous explanatory variables can lead to large inconsistencies in the IV estimates even if only a weak relationship exists between the instruments and the error in the structural equation. Second, in finite samples, IV estimates are biased in the same direction as ordinary least squares (OLS) estimates. The magnitude of the bias of IV estimates approaches that of OLS estimates as the R(2) between the instruments and the endogenous explanatory variable approaches 0. To illustrate these problems, we reexamine the results of a recent paper by Angrist and Krueger, who used large samples from the U.S. Census to estimate wage equations in which quarter of birth is used as an instrument for educational attainment. We find evidence that, despite huge sample sizes, their IV estimates may suffer from finite-sample bias and may be inconsistent as well. These findings suggest that valid instruments may be more difficult to find than previously imagined. They also indicate that the use of large data sets does not necessarily insulate researchers from quantitatively important finite-sample biases. We suggest that the partial R(2) and the F statistic of the identifying instruments in the first-stage estimation are useful indicators of the quality of the IV estimates and should be routinely reported.d
We analyze the effects of competition on price dispersion in the airline industry, using panel data from 1993:Q1 through 2006:Q3. Competition has a negative effect on price dispersion, in line with the textbook treatment of price discrimination. This effect is pronounced for routes with consumers characterized by relatively heterogeneous elasticities of demand. On routes with a homogeneous customer base, the effects of competition on price dispersion are smaller. Our results contrast with those of Borenstein and Rose, who found that price dispersion increases with competition. We reconcile the different results by showing that the cross-sectional estimator suffers from omitted-variable bias. (c) 2009 by The University of Chicago. All rights reserved..
We model firms as supplying utility directly to consumers. The equilibrium outcome of competition in utility space depends on the relationship pi(u) between profit and average utility per consumer. Public policy constraints on the "deals" firms may offer affect equilibrium outcomes via their effect on pi(u). From this perspective we examine the profit, utility; and welfare implications of price discrimination policies in an oligopolistic framework. We also show that an equilibrium outcome of competitive nonlinear pricing when consumers have private information about their tastes is for firms to offer efficient two-part tariffs.
The authors study dispersion in the prices an airline charges to different passengers on the same route. This variation in fares is substantial: the expected absolute difference in fares between two passengers on a route is 36 percent of the airline's average ticket price. The pattern of observed price dispersion cannot easily be explained by cost differences alone. Dispersion increases on routes with more competition or lower flight density, consistent with discrimination based on customers' willingness to switch to alternative airlines or flights. The authors argue that the data support models of price discrimination in monopolistically competitive markets. Copyright 1994 by University of Chicago Press.
A replication and extension of a study performed by Bearden and Etzel are reported in this article. The influence of peers on individuals' products and brand decisions for products that range in their degree of conspicuousness is examined for comparable samples in the United States and in Thailand to assess the validity of the original framework over time and across cultural contexts. Further, the influence of the family is addressed through an examination of intergenerational influences across the two cultures. The results of the study lend support to the original theoretical approach and also provide insight into how reference-group influence may vary depending on whether the influence is exercised by a member of a peer group or by a family member. Copyright 1992 by the University of Chicago.
This paper considers a nonlinear pricing framework with both horizontally and vertically differentiated products. By endogenizing the set of consumers served in the market, we are able to study how increased competition affects nonlinear pricing, in particular the market coverage and quality distortions. We characterize the symmetric equilibrium menu of price-quality offers under different market structures. When the market structure moves from monopoly to duopoly, we show that more types of consumers are served and quality distortions decrease. As the market structure becomes more competitive, the effect of increased competition exhibits some non-monotonic features: when the initial competition is not too weak, a further increase in the number of firms leads to more types of consumers being covered and a reduction in quality distortions; when the initial competition is weak, an increase in the number of firms leads to fewer types of consumers being covered, though the effect on quality distortions is not uniform.
The Chamberlinian monopolistically competitive equilibrium has been explored and extended in a number of recent papers. These analyses have paid only cursory attention to the existence of an industry outside the Chamberlinian group. In this article I analyze a model of spatial competition in which a second commodity is explicitly treated. In this two-industry economy, a zero-profit equilibrium with symmetrically located firms may exhibit rather strange properties. First, demand curves are kinked although firms make "Nash" conjectures. If equilibrium lies at the kink, the effects of parameter changes are perverse. In the short run, prices are rigid in the face of small cost changes. In the long run, increases in costs lower equilibrium prices. Increases in market size raise prices. The welfare properties are also perverse at a kinked equilibrium.
Economic theory suggests that a monopolist can price discriminate more successfully than can a perfectly competitive firm. Most real-life markets, however, fall somewhere in between the two extremes. What happens as the market becomes more competitive: Does price discrimination increase or decrease? This paper examines how price discrimination changes with market concentration in the airline market. The paper uses data on prices and ticket restrictions across various routes within the United States, controlling for distances and airport gate restrictions. Price discrimination is found to increase as the markets become more competitive.
Quantity-Based RM.- Single-Resource Capacity Control.- Network Capacity Control.- Overbooking.- Price-based RM.- Dynamic Pricing.- Auctions.- Common Elements.- Customer-Behavior and Market-Response Models.- The Economics of RM.- Estimation and Forecasting.- Industry Profiles.- Implementation.
This paper empirically examines the effect of competitive conditions on nonlinear pricing strategies in the airline industry. We use a unique data set to analyze the impact of concentration and the competitive pressures generated by Southwest and other low cost carriers on the relative prices within a menu of fares. The menu orders tickets by quality based upon cabin and ticket restrictions. We analyze the ratio of fares charged for various qualities within the menu to the fares charged for the lowest quality nonrefundable, restricted tickets. We observe a fare compression for only the highest fares on only the most concentrated (i.e., monopoly) routes. This result is something of a puzzle given a monopolist's market power. We find, however, that actual and potential competition from Southwest reduces low end fares and generally leads to substantial fare compression throughout the fare menu. (JEL L11, L93)
This paper extends recent research on the fare impacts of low-cost carriers, incorporating its adjacent-airport approach to offer a comprehensive picture of the competitive effects of both legacy carriers and low-cost carriers. The analysis measures the impact of in-market (i.e., airport-pair) competition and adjacent competition for both types of carriers, while also capturing the impact of potential competition from low-cost carriers. Moreover, this comprehensive approach is applied separately to two different types of markets, nonstop and connecting, which have not been simultaneously treated before within a single study. The results show that most forms of legacy-carrier competition have weak effects on average fares. Low-cost carrier competition, on the other hand, has dramatic fare impacts, whether it occurs on the airport-pair, at adjacent airports, or as potential competition.
This paper investigates the price-setting behavior of full-service airlines in the European passenger aviation market. We develop a model of airline competition, which accommodates various market structures, some of which include low-cost players. Using data on published airfares of Lufthansa, British Airways, Alitalia and KLM for the main city-pairs from Italy to the rest of Europe, our empirical findings substantially confirm the propositions of the theoretical model. We find that competition among full-service carriers appears to affect the price levels of the business and the leisure segments asymmetrically: there are small reductions in the leisure segments and significant reductions in the business segment of the aviation market. In contrast, competition with low-cost carriers reduces both the business and leisure fares of full-service carriers quite uniformly, with an emphasis on the mid-segment fares.
A basic premise in the development of yield management has been that the differentiated fare products offered by airlines are targeted to distinct segments of the total demand for air travel in a market, each of which compete for space on a fixed capacity aircraft. Such representations of differential pricing assume that the airline can segment its demand perfectly and without cost to consumers, and further, ignore the dependence of the demand for a given fare product on the price levels and characteristics of the other available fare products. In this paper, we introduce a new generalised cost model of fare product differentiation that incorporates the relationships between available airline fare products as well as the cost incurred by consumers of accepting more restrictions. We extend the model to incorporate the diversion of passengers to lower-priced fare products as a result of their ability to meet the additional restrictions imposed by airlines, and then demonstrate how seat inventory control can be used to induce diverting passengers to sell up to higher-priced fare products by applying booking limits. An example of how the model can be used for joint fare product price level optimisation is presented, along with a numerical example that illustrates the extent to which the conventional model of price discrimination over-estimates passenger demand and, in turn, total airline revenues.
The purpose of this paper is to develop a theory of market segmentation based on consumer self-selection. The extant theory is based on the third-degree price discrimination model of Pigou, central assumptions of which are that the firm can directly address individual segments and isolate them. By using consumer self-selection, I am relaxing these assumptions. In the context of a monopolist designing a product line, I show that this relaxation has significant implications for how the products and prices are chosen and what they look like. In particular, segments may be aggregated even though there are no economies of scale. Furthermore, consumer self-selection enables us to model “cannibalization” and competition among firms.
This paper develops a Hotelling model with discrete product and consumer types. We analyze the impact of horizontal differentiation (competition intensity) on relative prices. We find that the optimal price ratio of high- to low-quality products decreases with less competition.
This article considers the effect of airline hub-and-spoke systems on the entry and exit behavior of rival firms in the U.S. airline industry. An analysis of simple entry and exit decisions provides insight into equilibrium conditions that are used to specify discrete choice econometric models. The empirical evidence indicates that hub-and-spoke network characteristics are significant determinants of entry and exit decisions in individual citypair markets.
Fashions are characterized by fragility of mass behavior and a Life-cycle trajectory. We argue that fashions may be generated by the simultaneous presence of local externalities and word-of-mouth communication. We develop a model based on these two ingredients and show that in order for fashions to arise, communication has to be segmented across social groups. Our explanatory framework is consistent with views of sociologists and marketing experts about fashion. (C) 1999 Elsevier Science B.V. All rights reserved. JEL classification: D11; M30.
The history of entry and exit by low-cost carriers in Australia is outlined; two phases of entry are identified, the early 1990s, and the year 2000. The factors influencing success or failure are examined in the light of experience in North America and Europe. The strategies adopted by the low-cost carriers are examined, as are the competitive responses of the incumbents. The impacts made by low-cost carriers on fares, costs and profitability are examined and lessons are drawn from the experience. The likely patterns of competition between Virgin Blue and Qantas are explored along with the scope for more entry.
This paper estimates a model of spatial multiproduct duopoly pricing when the location patterns differ across markets. The theoretical model suggests that the neighbouring configuration yields less competitive Nash prices than the interlaced configuration. I apply this model to data for intra-European duopoly airline markets. The empirical results support the theoretical model since I find that fares are higher on intra-European markets that exhibit neighbouring configurations in the time domain. This result suggests that price competition is reduced when each airline operates on a specific segment of the timetable (e.g. the first 12 hours of the day). Clearly, this result has several implications for policy makers and/or airport authorities in charge of awarding slots.
We study an oligopoly model with asymmetric information and product differentiation. The analysis focuses on credit markets. We assume information to be asymmetric with respect to customer characteristics that directly affect bank profits. We analyze the impact of horizontal differentiation, which serves as an index for the degree of competition among banks, on loan-granting practices. We show that with more differentiation (less competition), banks may screen credit applicants less intensively in equilibrium because they compete less aggressively for the most profitable customers. As a result, welfare may actually increase as competition becomes less intense. Total profits may either increase or decrease with the introduction of asymmetric information.
While recent studies of deregulated airline prices considerably advance our understanding of competitive structure in this industry, they suffer from several weaknesses that could potentially undermine their inferences. In this article, we consider an alternative approach to this issue that uses the reactions of incumbent airlines' stock prices to announcements of entry by People Express to shed light on competitive structure. These stock reactions reveal significant route-specific profits or sunk costs (rejecting, for example, the contestable market model) and also provide evidence on the degree of competitive localization present in the industry. We also examine the price, sales quantity, and schedule changes that followed entry. These changes corroborate the conclusions emerging from our analysis of stock price reactions.
This article estimates the importance of route and airport dominance in determining the degree of market power exercised by an airline. The results indicate that an airline's share of passengers on a route and at the endpoint airports significantly influences its ability to mark up price above cost. The high markups of a dominant airline, however, do not create much of an "umbrella" effect from which carriers with smaller operations in the same markets can benefit. The article suggests a number of possible explanations for this asymmetry.
We estimate a model of city-pair entry for Southwest Airlines using data from 1990 to 2000. In addition to quantifying the market characteristics which have influenced Southwest’s entry decisions, we find evidence that Southwest’s entry strategies have changed significantly throughout the decade. Based on our model’s estimates, we provide an estimate of the foregone fare savings resulting from the Wright and Shelby Amendments. Finally, we identify those markets that are the most likely for future non-stop entry and suggest which network carriers are most vulnerable to future Southwest expansion. Copyright Kluwer Academic Publishers 2004
The canonical selection contracting programme takes the agent's participation decision as deterministic and finds the optimal
contract, typically satisfying this constraint for the worst type. Upon weakening this assumption of known reservation values
by introducing independent randomness into the agents' outside options, we find that some of the received wisdom from mechanism
design and nonlinear pricing is not robust and the richer model which allows for stochastic participation affords a more general
empirical specification. We develop a multidimensional methodology for addressing this class of problems, providing two important
applications to nonlinear pricing. First, with nonlinear pricing by a monopolist the familiar “nodistortion-at-the-top” result
persists, but in tandem with the surprising conclusion that there is either no distortion at the bottom or bunching. Second,
in a simple model of product differentiated duopolists competing with nonlinear pricing we show that, generally, the duopoly
outcome is qualitatively similar to the monopoly outcome. However, when marginal costs are symmetric and competition is sufficiently
intense, distortions disappear and the equilibrium outcome takes a remarkably simple form: efficient quality allocations with
cost-plus-fee pricing.
Economics is broadening its scope from analysis of markets to study of general social interactions. Developments in game theory, the economics of the family, and endogenous growth theory have led the way. Economists have also performed new empirical research using observational data on social interactions, but with much less to show. The fundamental problem is that observable outcomes may be generated by many different interaction processes, so empirical findings are open to a wide variety of interpretations. To make sustained progress, empirical research will need richer data, including experiments in controlled environments and subjective data on preferences and expectations.
This paper develops asymptotic distribution theory for instrumental variables regression when the partial correlations between the instruments and the endogenous variables are weak, here modeled as local to zero. Asymptotic representation are provided for various statistics, including two-stage least squares and limited information maximum likelihood estimators, Wald statistics, and statistics testing overidentification and endogeneity. The asymptotic distributions provide good approximations to sampling distributions with ten-twenty observations per instrument. The theory suggests concrete guidelines for applied work, including using nonstandard methods for construction of confidence regions. These results are used to interpret J. D. Angrist and A. B. Krueger's (1991) estimates of the returns to education.
This paper considers the effect of an airline's scale of operation at an airport on the profitability of routes flown out of that airport. The empirical methodology uses the entry decisions of airlines as indicators of underlying profitability; the results extend the empirical literature on airport presence by providing a new set of estimates of the determinants of city-pair profitability. These estimates imply that city-pair profits increase in airport presence and decrease rapidly in the number of entering firms. The literature on empirical models of oligopoly entry is also extended via a focus on the role of differences between firms. Copyright 1992 by The Econometric Society.
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