Main summary
This article has been updated from the original version published on October 12, 2023.
A new paper co-authored by Olivia Natan of Berkeley Haas and published in The quarterly economics magazine Examine the black box of airline pricing and find some surprises.
Buy your ticket on a Tuesday. Search in your browser’s incognito mode. Use a VPN to pretend you live in Suriname.
«There are a lot of tricks to finding cheaper airline tickets,» says Olivia Natan, assistant professor of marketing at the Haas School of Business. «But our data shows that many of these beliefs are wrong.»
With four colleagues (Ali Hortaçsu and Timothy Schwieg of the University of Chicago, Kevin Williams of Yale, and Hayden Parsley of the University of Texas at Austin), Natan took an in-depth look at the structure and processes behind how prices are set in a major American airline. The system he found, which is representative of airlines around the world, was strikingly at odds with what many economists would expect (and most consumers assume).
«At first we didn’t know how to rationalize the things we saw,» he says.
Replacing price with convenience
Consider buying fruit jam at the supermarket. Consumers have many options. If a company increases the price of its strawberry jam, one might assume that this would affect sales of both strawberry and raspberry jam, since consumers may substitute one for the other.
The same can happen with airline tickets: when people visit a website like Google Flights or Kayak and search for a ticket, a wide range of different flights on the same airline appear. Travelers tend to make selections that balance convenience and price: the price of a flight can push people to select a slightly less convenient but cheaper flight.
«But the systems that airlines use do not consider this type of substitution,» says Natan. They set seat prices on each individual flight on a given route separately, «although changing the price on one flight will affect the way people think about all their options.»
A small menu of pre-established prices
Perhaps most surprisingly, airlines also do not directly incorporate their competitors’ prices into their automated pricing. Normally, if one airline reduces its prices, other companies would be expected to do the same. If they don’t, this reduces the benefits of a competitive market.
Pricing each product separately without considering substitution, Natan explains, is the result of a specific pricing heuristic – or decision-making shortcut – that airlines use, called Expected Marginal Revenue per Seats-b. or EMSRb. This shortcut is widely used because it is fast enough to set prices for hundreds of thousands of daily flights and allows airlines to reserve some seats to sell at higher prices.
Researchers show that using EMSRb produces another result that consumers may not expect. Despite what it may seem when searching for flights, airlines have a fixed and relatively small number of prices that they assign to tickets for each flight. Unlike other consumer sectors, where prices can be adjusted and guided down to the last cent, airlines operate with large gaps between every possible price, sometimes more than $100. They might sell the first 30 economy tickets at the lowest price, then the next 30 tickets at the next possible price, and so on.
«Airline tickets are sold through global distribution systems that ensure a travel agent in Wichita or Miami sees the same price as you on your computer at home,» says Natan.
This system emerged from an industrial alliance to facilitate inventory management across many channels. Other companies in the travel sector, such as hotel rooms, cruises, trains and car rentals, do the same.
The downside is that airline ticket prices are relatively insensitive to real-time changes in opportunity costs, as the next discrete fare is usually a significant increase. The researchers found that even if the airline wanted to increase the price by $100 (half the price of an average one-way ticket) they only do it about 20% of the time, since there are no fares available at that price.
Today, airlines are starting to experiment with what’s known as «continuous revenue management,» which would assign, for example, 100 different prices to a flight with 100 seats.
«That would make prices significantly more variable,» Natan says, «but even that wouldn’t be the kind of guidance that many consumers assume airlines use.»
Lack of coordination between departments
One of the strangest discoveries of the investigation relates to the process airlines use to set their prices. For an economist, Natan explained, there is never a reason why companies should not increase prices if the increase guarantees an increase in income. But the set of possible prices chosen by the pricing team almost always includes an option that is too low, even by their internal estimates.
The pricing team’s job is made difficult by having to choose from an entire menu of discrete prices.
«We found that they could make more money today by selling fewer tickets at higher prices and without excluding future opportunities. In practice, they choose the price menu without using their internal demand predictions,» says Natan.
Interestingly, the revenue management team corrects much of this underpricing before it reaches consumers. Once the prices are presented and before the tickets go on sale, this team makes demand forecasts that determine the final prices. These forecasts are routinely inflated, reducing the number of low-priced tickets shown to consumers by approximately 60%.
«We found that these prices are a consequence of teams from different departments choosing the best prices when they cannot coordinate,» says Natan. «This may result in lower revenue, but in practice our solution could not be implemented.»
Two other possibilities for why airlines aren’t just focusing on short-term revenue, he speculated, are to build customer loyalty or avoid regulatory scrutiny.
In the coming years, Natan says, airlines may begin to adopt more dynamic pricing platforms, and non-business travelers may benefit from these changes. But for now, the search for an undiscovered trick to finding lower rates is largely futile. What is clear is that it is advisable not to wait until the last moment.
«What I can say is that prices rise significantly 21, 14 and seven days before the flight,» says Natan. «Just buy your ticket before then.»
By Ali Hortaçsu, Olivia Natan, Hayden Parsley, Timothy Schwieg and Kevin Williams – The Quarterly Journal of Economics, September 27, 2023.
