Airline pricing and fare product differentiation: A new theoretical framework

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.