How Price Dispersion Changes when Upgrades are Introduced: Theory and Empirical Evidence from Airline Industry

56 Pages Posted: 10 Feb 2017 Last revised: 30 Jan 2018

Yao Cui

Cornell University - Samuel Curtis Johnson Graduate School of Management

A. Yesim Orhun

University of Michigan, Stephen M. Ross School of Business

Izak Duenyas

University of Michigan, Stephen M. Ross School of Business

Date Written: January 29, 2018

Abstract

This paper studies the effect of introducing a vertical differentiation strategy through sales of upgrades to a new type of premium product on the firm's price dispersion arising from its use of price discrimination for the base product. As a relevant application, we examine, both analytically and empirically, how a major U.S. airline's price dispersion in the coach cabin changed after it introduced the option to upgrade to a new type of premium economy seating within the coach cabin. We first provide a theoretical analysis that highlights two competing pressures that the new premium economy seating upgrades created on coach class prices. On the one hand, the airline benefits from lowering its prices because by allowing more customers to purchase in the first place, it increases the probability of selling upgrades (admission effect). On the other hand, for some customers, the value of flying with the airline increases due to the upgrade availability, therefore the airline may find it optimal to increase its prices (valuation effect). In the second part of the paper, we conduct an empirical investigation of the impact of upgrade introduction on coach class prices based on a proprietary transaction-level dataset from a major U.S. airline company. The empirical analysis tests the main predictions of our theoretical model and examines further nuances. The results show that the introduction of the premium economy seating upgrades is associated with an increase in the price dispersion and revenues in the coach class, the admission effect is stronger than the valuation effect on the low-end of the price distribution, and the opposite is true on the high-end of the price distribution. Finally, we provide the insight that the upgrade strategy can increase both firm revenue and consumer surplus and therefore create a win-win situation.

Keywords: price dispersion; price discrimination; upgrades; airline industry; causal inference; quasi-experiment; difference-in-differences

Suggested Citation

Cui, Yao and Orhun, A. Yesim and Duenyas, Izak, How Price Dispersion Changes when Upgrades are Introduced: Theory and Empirical Evidence from Airline Industry (January 29, 2018). Available at SSRN: https://ssrn.com/abstract=2914625 or http://dx.doi.org/10.2139/ssrn.2914625

Yao Cui (Contact Author)

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

Ithaca, NY 14853
United States

A. Yesim Orhun

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

Izak Duenyas

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

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