Fare dispersion has grown since deregulation. According to the TRB, there were two general reasons why buyers, in any industry, may be charged different prices for products that appear to be the same or nearly the same for reasons that are “both efficiency-and welfare- enhancing.“ These were:
• That the direct costs of supplying different prices to different groups of customers are in fact different, such as the costs associated with delivering the product to the point of sale.
• That costs are incurred in circumstances in which, while the products and costs of supplying them are effectively similar significant economies of scale and scope were operating in the supply of the different airline products. When a firm sells the same product or almost identical products at different prices to different buyers (or at different mark-ups on marginal cost), price discrimination is said to have occurred. Under the latter circumstance, prices set uniformly at their marginal costs would not recover the total costs of supplying them, including fixed and overhead expenses, and it becomes necessary to charge buyers collectively prices in excess of incremental cost if the products are to continue to be supplied. In this situation, if the seller can take advantage of the fact that buyers attach widely different values to the same product and segment buyers on the basis of their different product valuations, an airline can charge prices that are above marginal cost to those who are least sensitive to price. The seller may then generate sufficient revenue to provide all the different
products. Excessive overall price exploitation would be avoided if effective competition is at a sufficient level. 215)
The major airlines claimed that fare differentials (that is, variations in fares between business and leisure travellers) are caused in large measure by direct differences in cost, such as those associated with flying during peak or congested periods. Unfortunately, the TRB noted that too little empirical evidence was submitted by the airlines to support this main assertion. The TRB considered the possibility that too many common or shared costs may exist in the airline industry, making the allocation of cost among different classes of services arbitrary. 216)
3.10.4 RAMSEY PRICING WITHIN THE AIRLINE INDUSTRY
The TRB stated that generally economists have maintained that prices set at a level equal to the marginal costs of producing goods or services are optimal (that is, welfare maximising). Problems can arise, however, if marginal costs are less than average costs at levels of output that would prevail if prices had been set uniformly to all buyers. In this situation the revenue raised by marginal cost pricing will not cover total costs and the producer will not be able to continue to provide the product as it will not be economic to replace equipment and other capital in the long term. The loss of the product may create welfare losses, particularly among those consumers who valued it highly. 217)
A well-known theorem in economics, known as Ramsey pricing (named after one of its earliest proponents), holds that the welfare losses created by deviating from marginal cost pricing are minimised if the buyers with inelastic demands are charged the highest prices or mark-ups above the marginal cost. Including the overhead, fixed, and other costs that comprise total costs (that are otherwise excluded from marginal costs) in the prices charged these buyers with inelastic demand results in the least deviation of consumption patterns from the patterns that would be achieved if uniform prices were set at marginal cost. 218)
The TRB stated that something akin to Ramsey pricing might be practised in the airline industry. Leisure travellers who are sensitive to price (price-elastic) are charged fares roughly equal to the marginal cost of serving them, but which are apparently insufficient in the aggregate to cover the full cost of maintaining the airline networks as they are now
constituted. US airlines must cover their total costs by competing for capital in private financial markets. As Ramsey pricing would suggest, they apparently cover any shortfall in revenues from leisure travellers by charging higher prices, or whatever the traffic will bear, to price-inelastic business travellers. In the process, moreover, the airlines may have been able to finance a more extensive network than would have been possible otherwise. 219)
The TRB also stated that those who make the extra contributions are seldom content with this role. Some may believe they are being held captive to their inelastic demands as a result of various actions taken by the airlines, such as possible exclusionary behaviour to hold back new entrants or technologies such as smaller, “regional” jets. A traditional role of economic regulation, particularly in telecommunications and transportation, has been to smooth out these surcharges by making them uniform over broad classes of customers, and in the process making them more politically acceptable. This was usually achieved, with some sacrifice in welfare (by attenuating the mark-ups on the most inelastic buyers while increasing them on buyers who are somewhat more sensitive to price). The TRB was of the opinion that the politically acceptable solution usually led to greater deviation in consumption patterns (from the marginal cost optimum) than would a strict Ramsey pricing solution. 220)
The TRB stated that, while “a Ramsey pricing scheme can be beneficial in the short-term, it may be less desirable in the long-term. The Ramsey pricing optimum is strictly static in character, unless prices adjust quickly or producers have considerable foresight. Ramsey pricing optimality will be undermined by any changes in the demand elasticity and other conditions on which it is defined. Indeed, Ramsey pricing creates its own strong incentives for change. Buyers paying the highest prices, or mark-ups, have incentives to seek alternatives to the high-priced service. Over time, they will be increasingly successful in finding such alternatives, or in otherwise adjusting their circumstances to become less reliant on the product, thus making much of the existing capacity redundant for some period of time or until industry capacity can be properly adjusted. New technology and other changes and alternatives (including new competitors) that undermine an established Ramsey pricing pattern will be unwelcome to incumbent producers”. The TRB was of the view that in the long term, sustaining such a pricing scheme will usually require government regulation or monopoly power to bar entry and producers pricing under a Ramsey pricing scheme would be likely to be hostile to change, even if the change would be otherwise beneficial to consumers. The Committee’s view was that some of the most counterproductive experiences
with industry economic regulation have been associated with regulatory regimes to maintain highly discriminatory pricing by delaying technological changes that would otherwise have been desirable. As such, they were of the opinion that any price discrimination should sustain itself only if tested by open entry and competition. 221)
The TRB stated that “evidence of growing fare dispersion has not been supported by evidence of growing cost dispersion”. Nevertheless a very substantial portion of the fare differences is explicable in terms of the direct costs of the two kinds of services. The economies gained from density (e.g., denser routes permit larger planes, with correspondingly lower costs per seat mile) suggest that fares will typically be lower in dense markets than in thin ones. Differing constraints on airport and airway capacity, including terminal charges, can also contribute to differentials in costs, and therefore variations in fares across markets. Likewise, fares paid by travellers in the same markets can vary widely as a result of differences in the cost of travelling at different times of the day and week. One would, for instance, expect higher fares for travel during peak times when demand is greatest and resources are tight. Travellers booking early are less costly to serve than travellers booking much later, as holding unsold seats in anticipation of late-booking travellers increases the risk that the seat will fly empty. Business travellers pay higher fares in part because they tend to be late bookers, whereas leisure travellers, who pay the lowest fares, tend to be early bookers. When demand for seats is high, the cost of holding a seat empty in anticipation of late-booking or “walk-up” travellers, that is, the opportunity cost incurred if the seat is not eventually sold, may be high. This cost may be reflected in higher fares for travellers who book late or make last-minute itinerary changes. 222)
The TRB observed that much of the spread in airline fares may be explained by cost differences, but not all the spread can be so explained, and some is the result of price discrimination. It noted that airlines have long been able to sort travellers according to their relative price elasticity by imposing various ticket restrictions. The TRB concluded that the general ability of airlines to price discriminate might be advantageous to travellers on balance, at least in the short run. The argument that some price discrimination in the airline industry can be desirable rests to a large degree on the recognition that the type of product demanded by schedule-sensitive business travellers differs significantly from the product demanded by price-sensitive leisure travellers. On short-haul flights, the difference in preferences between the two kinds of travellers may be the greatest. Leisure travellers in
these markets are especially sensitive to price owing to the substitutability of driving as a travel option. Flight frequency may be especially important to business travellers, since saving relatively small amounts of time is, after all, one of the main reasons for their decision to fly (rather than drive) in the first place. By being able to identify leisure travellers through ticket restrictions, the price-discriminating airline can offer discounted fares to fill unsold seats on flights that might otherwise fly partially empty, but at the same time not permit business travellers to routinely take advantage of these lower fares. The TRB were of the opinion that should an airline not have the ability to restrict access to low fare tickets by time-sensitive travellers, the airline might not be able to cover the total cost of providing the frequent and extensive service. Where airline operations entail large economies of both scale and scope (and thus, declining average costs), as in hubs (where the number of routes that can be served from the hub increases disproportionately with an increase in the number of scheduled flights) it is possible that fares set uniformly at marginal cost would generate insufficient revenue to recover total costs, necessitating discriminatory pricing if the hub airline is to maintain the service. Price discrimination allows carriers to cover both the operating and capital costs of providing the schedule-intensive service desired by business travellers, while filling empty seats with leisure travellers whose low fares at least cover their incremental, or marginal, cost. 223)
The possibility that airlines have become too skilled at identifying price-inelastic travellers and charge them excessive fares, above the level necessary to efficiently provide the service, can be identified if the price discriminating airline is reaping monopoly profits (excessive returns on capital). Such determinations are difficult, involving projections of airline profits and the effects of the business cycle. A protection against such exploitation is free entry. Where entry is not artificially impeded, competing services will ensure that the fares charged to price-inelastic travellers are, in the long-run, reflective of the full (or stand-alone) cost of efficiently providing the type of service desired. 224)
Some uniformly low cost carriers, such as SWA, have discovered that business travellers are not completely insensitive to price and are sometimes willing to accept fewer schedule options in return for substantial fare reductions. In dense markets where airlines charge excessive fares to price-inelastic travellers, competition from non-network, point-to-point, and low cost airlines can be expected, especially in the light of the high overhead and fixed costs associated with creating a brand new, competing hub-and-spoke system. As a result,
new low fare services tend to focus on dense markets only, where point-to-point service can be economical. Airline service in many thinner markets (often important to business travellers) generally remains the domain of the larger carriers with their larger (and higher fixed cost) networks. The introduction of smaller regional jets, and other new technologies, may, however, change this situation. 225)
3.10.5 FARE RESTRICTIONS AS A MEANS OF DIFFERENTIAL
PRICING
Before deregulation, airlines concentrated on business travellers. Unscheduled charter service was permitted for some low fare travel (e.g., tour packages), but in general, the price- sensitive market was neglected. But by the mid-1960s, regulated airlines were increasing their use of discount economy fares to attract more leisure passengers to fill seats on their new larger-capacity jet aircraft. Senior citizens, students, and relatives of travellers flying on full fares were offered discounts of up to 25 percent. Using such differential methods of pricing, airlines could identify and attract price-sensitive traffic without marking down the fares charged to regular business travellers. The airlines maintained, and the CAB regulators presumed, that such discriminatory pricing was needed to ensure the long-run profitability of the service. Though seldom able to purchase the discounted fares, business travellers were thought to have benefited owing to the more frequent flights that were available from these larger aircraft. 226)
Some economists predicted that deregulation would diminish airlines’ ability to differentiate among types of travellers, because of a general belief that monopoly power (or regulatory protection) was required for discrimination and a lack of understanding of the economies of scale and scope that would come to characterise a post-deregulation industry. According to this view, new and incumbent airlines would tailor their services to particular kinds of travellers. For example, single-class, service-intensive airlines would cater to business travellers by providing more spacious seating, frequent departure times, and generous in- flight amenities, but charging uniformly high fares to cover the cost of premium service. Meanwhile, “no-frills” airlines would emerge, offering off-peak, low fare services for mostly leisure passengers. Under these scenarios, the variation in fares paid by travellers seated side- by side on the same flight would be small. 227)
Although some new single-class carriers did emerge after deregulation, the incumbent airlines quickly realised that they could efficiently serve both business and leisure travellers on the same flights. Through hub-and-spoke networks and the economies of consolidating traffic at central hub airports, airlines could increase the number of scheduled flights from previous point-to-point schedules. The large increase in flight destinations and frequencies (i.e. the scope economies) were a boon to business travellers, particularly those travelling to cities with hub airports. Hub cities such as Charlotte, Cincinnati, and Detroit have experienced a 50 percent or more increase in scheduled jet departures since 1985. 228)
Airlines also recognises that leisure travellers - self-identified by their willingness to accept booking restrictions - could be accommodated on many of the same flights as time-sensitive travellers. Seats that otherwise would fly empty could be sold at a significant discount, yet still cover incremental, or marginal, costs. Start-up airlines focusing on leisure traffic - but unable to attract business travellers seeking frequent and convenient flights to numerous points - were at a significant disadvantage. Many failed within the first few years after deregulation. Moreover, it soon became evident that certain service amenities could be offered selectively to high-fare business travellers. These included accrual of free vacation trips, access to airport club lounges, upgrades to first class, and special boarding privileges. 229)
Since deregulation, airlines have fine-tuned their fares using a complex combination of purchase terms such as Saturday-night stay-over restrictions, advance purchase requirements, and penalties for cancellations and exchanges. Yield management practices in which airlines reassess on a flight-by-flight basis how many seats are to be offered at a discount, by how much, and when have proliferated and become more sophisticated with experience and advances in information technology. At any one time, an airline may be offering a dozen or more different economy fares on a given flight. FFPs, now offered by nearly all airlines; also identify the most loyal customers who generally are the most price-inelastic. These travellers receive additional bonus miles and other benefits, particularly when purchasing high-fare tickets. Airport security requirements that travellers must present personal identification before boarding have also enhanced the ability of airlines to price discriminate, as low fare travellers cannot resell their heavily restricted advance-purchase tickets (e.g. through intermediaries) to late-booking travellers, who must then pay the higher fares. 230)