Price Dispersion and Consumer Upgrade: Theory and Empirical Evidence from Airline Industry
44 Pages Posted: 10 Feb 2017
Date Written: February 7, 2017
In recent years, major U.S. airlines introduced the option to upgrade to premium economy seating which provides comfort-enhancing features compared to regular economy seating. This paper examines the effect of the introduction of this upgrade option on the airline’s price dispersion in the main cabin. We first provide a theoretical analysis of the airline’s optimal pricing policy when customers exhibit multi-dimensional heterogeneity, and the airline price-discriminates intertemporally for its regular economy seating and can offer an upgrade option to premium economy seating. Our analysis highlights two competing pressures on main cabin 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 the introduction of the upgrade option on main cabin 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 provides further insights. The results show that the introduction of the premium seating upgrade is associated with an increase in the price dispersion in the main cabin, 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.
Keywords: Price Dispersion, Price Discrimination, Upgrade, Airline Industry
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