Airline pricing and capacity behavior

Standard models of price dispersion (Butters, Varian, Burdett & Judd) give some explanation of how equilibria of firms selling the same product at different prices occur by providing consumers with dispersed information or loyalty but a common reservation price. This model extends these models by having business travelers paying more than tourists. There is a continuum of prices broken by a gap right above the monopoly price of the tourists. In this region, expected firm profits are lower, as firms do not make up for the discrete loss of leisure travelers. The model is compared to Data Bank 1A – a ten-percent random sample of airline ticket itinerary. Individual airline routes are shown to have up to several peaks in the estimated price kernel density. This is where the theory matches the data: airline fares cluster around prices. Kreps and Scheinkman generate a limited capacity model that generates price randomization when two firms have unequal capacities. The large capacity firm has the ability to set prices lower than the smaller firm. Butters, Varian, Burdett & Judd develop price dispersion models as described before. A symmetric two-firm model is developed that has both features, limited capacity and limited price information, thus unifying two disparate literatures. The lower price firm sells out to capacity, while the higher price firm receives the leftover customers from the sold out firm plus the loyal customers who did not see the lower priced firm. This leads to price randomization. Limited information and capacity are thus identical in economic effects. There is a variety of sizes of loyal customers within the airline, hotel, and car rental companies. A price randomization model is created with one large firm of loyal customers and many smaller firms having the same size of loyal customers. Firms randomize by charging the monopoly price for the loyal customers and discounting to obtain a group of shoppers seeing the lowest price of all the firms. The largest firm has an atom at the highest price in the distribution. The smaller firms compete for shoppers at all prices in the distribution and have no atom.