Flying into uncharted territory

A case where competition doesn’t improve market efficiency.

Alex Eben Meyer

Alex Eben Meyer

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Every business, from the corner bakery to an international airline, must figure out how to price its goods and services. Businesses that use “dynamic pricing” adjust their prices to account for market shifts.

Most airlines use dynamic pricing. The carriers use algorithms to set fares that can change daily, and consider factors from demand to fuel costs.

Research shows that dynamic pricing has positive effects on what economists call “welfare,” a combination of what’s good for consumers and what’s good for companies. But, much of the research on dynamic airline pricing has excluded an important factor: the element of competition.

Working with a colleague at the University of Chicago, associate professors Aniko Öry and Kevin Williams of Yale’s School of Management used data on airline pricing and booking to model a market in which two airlines serve the same route and compete for customers. “Our model showed that adding the element of competition to dynamic pricing—when every company is reacting not only to consumer demand but to each other—creates some unexpected market effects,” says Öry. (The paper was published by the National Bureau of Economic Research.)

Consider two airlines that reduce prices to the point where each sells too many seats too early, potentially leaving few seats available for those who book late. This situation hurts the airlines (who rely on the higher-paying last-minute customers) and the customers (who need that next-day flight). On the other hand, a carrier that set its own prices without considering a competitor’s prices—but while monitoring its rivals other ways—improved its revenue. It also increased what economists refer to as “consumer surplus,” paying lower-than-expected prices.

“Economists expect competition to improve market efficiency, and that was not the case here,” says Williams. “We are just beginning to understand the range of effects of dynamic pricing in various markets.”

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