Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Price Discrimination and Business-Cycle Risk

Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Price Discrimination and Business-Cycle Risk

Article excerpt

Working Paper 2011-3 March 2011

Abstract: A parsimonious theoretical model of second degree price discrimination suggests that the business cycle will affect the degree to which firms are able to price-discriminate between different consumer types. We analyze price dispersion in the airline industry to assess how price discrimination can expose airlines to aggregate-demand fluctuations. Performing a panel analysis on seventeen years of data covering two business cycles, we find that price dispersion is highly procyclical. Estimates show that a rise in the output gap of 1 percentage point is associated with a 1.9 percent increase in the interquartile range of the price distribution in a market. These results suggest that markups move procyclically in the airline industry, such that during booms in the cycle, firms can significantly raise the markup charged to those with a high willingness to pay. The analysis suggests that this impact on firms' ability to price-discriminate results in additional profit risk, over and above the risk that comes from variations in cost.

JEL classification: D4, L9, L1, E3

Key words: airlines, price discrimination, price dispersion, markup, business cycle

1 Introduction

Firms can expose themselves to fluctuations in demand by choosing specific pricing strategies. In this study, our aim is to better understand how price discriminatory tactics can make airlines vulnerable to aggregate demand risk. Given the large number of bankruptcies in this industry, there is reason to believe that airlines are particularly sensitive to movements in the business cycle. However, while many of the traditional, legacy airlines, including United Airlines, U.S. Airways, and Delta Airlines, have been forced to file bankruptcy, a select group, known as low-cost carriers (LCCs) have been able to stay profitable. The success of these LCCs has been impressive considering the extreme profit volatility that most airlines have had to endure during the post-regulation era.

While differences in cost likely play an important role in the variation in profits across airlines, we focus on a different potential explanation for the volatile nature of airline profits. We argue that price discrimination is a pricing strategy that accentuates profit variation over the business cycle. Price discrimination is a risky tactic in the sense that it exposes the firm to aggregate-demand movements and therefore induces greater revenue fluctuations. We find that relative to LCCs, legacy carriers price discriminate to a large degree, inducing high volatility in revenues. As legacy airlines generally have higher cost levels than LCCs, our results imply that legacy carriers' large revenue variation has been a major contributor to the large number of bankruptcies.

Price discrimination is a well-known strategy that airlines use to try to increase profits. It involves charging higher prices to those consumers with a lower price elasticity of demand, or equivalently, with a higher willingness-to-pay for an airline ticket. In this manner, airlines are able to increase the average markup of prices to marginal cost, and thus, increase their profits. In order to price discriminate, however, airlines must be able to identify and separate consumers with different willingness-to-pay, which they do by offering tickets with various types of restrictions so that consumers separate themselves through the ticket choices that they make (this type of self-selection is referred to as second-degree price discrimination). In this paper we present empirical evidence that suggests price discrimination in the airline industry is highly pro-cyclical. During booms it is easier for airlines to price discriminate between consumers, while in business cycle troughs it is much more difficult. This results in pro-cyclical average markups, and hence pro-cyclical airline profits. Furthermore, it suggests that airlines which rely more heavily on price discrimination strategies should expect more volatile profits over the business cycle. …

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