A-La-Carte Pricing in the Airline Industry - Graduate Student ...

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such a scenario faces strong incentives to position itself in the center of the distribution tocapture as many consumers as possible from the other firm. Despite a potential increase in totalwelfare if each firm positions itself at opposing quarters of the line, thus reducing the distanceconsumers would have to travel, this outcome is untenable given each firm‘s incentives.Hotelling points out that real-world firms competing for customers distributed in a qualityspace validate his theory: ―Buyers are confronted everywhere with an excessive sameness. Whena new merchant or manufacturer sets up shop he must not produce something exactly like what isalready on the market. . . . But there is an incentive to make the new product very much like theold, applying some slight change which will seem an improvement to as many buyers as possiblewithout ever going far in this direction‖ (54).Each airline‘s choice in product offerings can often be found to exhibit a number ofqualities of ―sameness‖ to the industry standard—most airlines have similar seat pitch, similarcabin class offerings, etc. Hotelling‘s classic model is, of course, an abstraction, especially due toa number of constraints on the model (such as normally distributed consumers and a one-productduopoly market). Salop (1979) elaborates on the Hotelling model by positioning multiple firmson an infinite line or unit circle and adds another outside commodity to the economy. Salop findsthat, in a similar manner to Hotelling‘s model, a firm faces low incentive to provide productvariety relative to the social optimum (152). This leaves customers worse off than they otherwisecould have been in the total welfare-maximizing setting.While airlines may face spatially distributed customers, unlike the firms in the Hotellingand Salop models, they do not charge constant per-unit prices for air travel. Rather than a linearpricing arrangement, airlines charge different prices based on distance flown, time of day, and avariety of other supply and demand factors. A carrier‘s fares do not necessarily exhibit a linear26
elationship: a flight that covers twice the distance as another will not necessarily cost twice asmuch (for example, a flight from New York to Washington, D.C. can often cost as much as aflight from New York to Las Vegas). Given these non-linear price arrangements and a spatialdistribution of customers, what sort of pricing arrangements can be expected?Armstrong and Vickers (2001) develop a framework for analyzing situations in whichfirms with non-linear pricing compete by offering ―deals‖ such as tariffs, bundles of outputs, etc.In a similar fashion to Hotelling‘s location model, Armstrong and Vickers‘ model positionsconsumers within a utility space, where consumers differ in their tastes for the product attributessupplied by firms. One of the key distinctions allowing for analysis of the effects of non-linearpricing is the fact that, instead of analyzing changes in consumers transportation costs per unit ofproduct consumed (the costs that consumers bear by moving from their position to purchase froma given firm), the authors‘ utility space involves a transport cost per product. In many ways, thistransport cost per product can be likened to an airline consumer‘s costs of moving away from herideal for an onboard product to buy the airline‘s offering.Armstong and Vickers analyze a competitive situation where customers haveheterogeneous tastes according to some characteristic that is unobservable by firms. Under theseconditions, they find that two-part tariffs based on marginal costs emerge as an equilibriumstrategy for each firm in the market. A later paper by the authors (2008) shows this result to be aunique equilibrium. Their result arises out of the authors‘ demonstration that under a Hotellingmodel, two-part tariffs emerge as an equilibrium solution for both firms because the firm is ableto effectively charge more to those who are spatially located closer and less to those locatedfarther away, thus catering to various groups of customers (Armstrong & Vickers 2001, 589).When customers exhibit some sort of unknowable private information, so long as it is27
Page 3 and 4: A-La-Carte Pricing in the Airline I
Page 6: IntroductionAnyone who has flown re
Page 10 and 11: Additionally, the chapter will prov
Page 12 and 13: compete with their rivals to attrac
Page 14 and 15: The Start of the Ancillary Revenue
Page 16 and 17: In these examples, this fee exists
Page 18 and 19: this strategy. Nonetheless, Button
Page 20 and 21: and/or services. This is because co
Page 22 and 23: new production process will have a
Page 24 and 25: entrepreneurial awareness that a mu
Page 26 and 27: Chapter 1 ReferencesAdams, William
Page 28 and 29: Sharkey, Joe. 2001. ―Business Tra
Page 30 and 31: Between 1993 and 2007 alone, averag
Page 34 and 35: uncorrelated with their spatial loc
Page 36 and 37: additional price differentiation di
Page 38 and 39: gallon to 298 cents per gallon: dur
Page 40 and 41: Despite these indications that the
Page 42 and 43: Despite this open question, it is c
Page 44 and 45: transactions at the airport. Histor
Page 46 and 47: The Role of Entrepreneurial Attenti
Page 48 and 49: additional legroom throughout its f
Page 50 and 51: ConclusionThis discussion in this c
Page 52 and 53: Chapter 2 ReferencesAir Transport A
Page 54 and 55: Morrell, Peter. 2005. ―Airlines W
Page 56 and 57: most recent quarter for publicly re
Page 58 and 59: variation is present, with peaks du
Page 60 and 61: compete for customers in a manner s
Page 62 and 63: always perfect, however. For exampl
Page 64 and 65: chance for bags to get delayed or g
Page 66 and 67: customers may pay to upgrade to a h
Page 68 and 69: than it would if it offered that pr
Page 70 and 71: airline‘s decision to offer a cer
Page 72 and 73: New Mexico Business Weekly. 2010.
Page 74 and 75: A number of interviewees pointed ou
Page 76 and 77: airline, and even the industry as a
Page 78 and 79: they have not significantly impacte
Page 80 and 81: potential to lower fares, but that
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Figure 4.3 - U.S. Airlines Average
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Figure 4.4: Ratio of JetBlue Airway
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emembered that this characterizatio
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One additional consideration that m
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there‘s . . . a quality issue the
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kit are able to keep the pillow and
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(such as meals, books, and blankets
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[certain customers] because there
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Chapter 4 ReferencesArmstrong, Mark
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Chapter 5: The Policy Implications
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Niskanen (1968) points to the budge
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Necessity is ultimately a term that
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who do not check luggage would end
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they are lowering their effective t
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Unsurprisingly, no airlines have cl
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each scenario, meaning that they se
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Figure 5.1: Ancillary Fee Disclosur
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unaware of certain airline pricing
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One important consideration involve
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Chapter 5 ReferencesArrow, Kenneth
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Niskanen, William A. 1968. ―The P
Page 124 and 125:
Far from being a mechanical solutio
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