Economics of Revenue Management: Pricing, Competition, and Seat Allocation.

Serguei Netessine*
The Wharton School, University of Pennsylvania

Robert Shumsky
W. E. Simon Graduate School of Business Administration University of Rochester

Email: netessin@wharton.upenn.edu

Rochester to Chicago Timetable, December, 2000

6:37 172 seats 9:39 172 seats 13:14 109 seats 16:53 172 seats 20:03 109 seats

American United
6:05 108 seats 7:25 155 seats 10:00 128 seats 13:13 108 seats 16:35 108 seats

21-day advance purchase round-trip: $289 14-day advance purchase round-trip: $318 7-day advance purchase round-trip: $798 Unrestricted full fare: $664 each way Same for both airlines
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Horizontal competition in US airline industry

From S. A. Morrison. 1998. Airline Service: The evolution of competition since deregulation.

The Full Revenue Management Game

Additional Assumptions Two noncooperative airlines, each with capacity C. Identical prices. Two passenger classes, H (High) and L (Low) fares. All passengers who cannot find a seat on one airline overflow to the other airline. The following order of events:
DL realized Accept low fare passengers DH realized Accept high fare passengers

Choose B1,B2

Accept overflow low fare passengers

Accept overflow high 4 fare passengers

The Full Game

DH1 B1 Min(B1,DL1)

Airline 1 High fare class (DH1 - R1)+ (DH2 - R2)+

Airline 2 High fare class B2 Min(B2,DL2) DH2

DL1

Low fare class

(DL1 - B1)+ (DL2 - B2)

+

Low fare class

DL2

T DLi = D Li + ( DLj B j ) + = total low-fare demand T Ri = C min( D Li , Bi ) = space available for high-fare

T DHi = DHi + ( DHj R j ) += total high-fare demand

The Full Game

Airline 1s objective:

T T 1 ( B1 , B2 ) = E p L min( DL1 , B1 ) + p H min( DH 1 , R1 )

First-order conditions
T T T p L Pr( DL1 > B1 ) p H Pr( DH 1 > C B1 , DL1 > B1 ) T T p H Pr( DL1 > B1 , DL 2 < B2 , DH 2 > R2 , DH 1 < C B1 ) = 0

Two Airline Response Functions and Nash Equilibria

With C = 200.
200 150

50 40
r2(B1)

r2(B1) r1(B2)

30 B2
r1(B2)

B2

100 50 0 0

20 10

50

100

150

200

B1

0 0

10

20 B1

30

40

50

E(DL) > E(DH)

E(DL) << E(DH)

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For both examples, correlation(DL, DH) = 0

Example: No Pure-Strategy Equilibrium

200

r2(B1)
150

B2 100
50 0

r1(B2)

50

100

150

200

B1

correlation(DL, DH) = -0.9

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Partial Games High-fare overflow only (no low-fare overflow) A good approximation if low fare demand is high A pure strategy equilibrium must exist. Under certain assumptions, equilibrium is unique.

Low-fare overflow is delayed until the end of the game. A pure strategy equilibrium must exist.
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Competition vs. Monopoly

A monopoly maximizes the sum of the profits of both flights (# available seats = 2C) What can we say about total booking limit?
Total booking limit (B1+B2)

330 320 310 300 290 280 270 260 250 -0.2 0 0.2 0.4 0.6 0.8
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monopoly competition

correlation(DL,DH)

Impact on Service Level

service level = proportion of passengers served by either flight

0.9 0.8

competition monopoly

Service Level

0.7 0.6 0.5 0.4

High-fare service level

monopoly competition
-0.2 0 0.2 0.4 0.6 0.8

Low-fare service level

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correlation(DL,DH)

Insights

Instability of full game Pure-strategy equilibrium in partial games One partial game (high-fare overflow only) is sometimes a good approximation to the full game. Lower booking limits under competition (analytically confirmed for a partial game). Impact on customer service.
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Fixed prices assumption

From S. A. Morrison and C. Winston. 1995. The evolution of the airline industry.

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Evolution of prices

From S. A. Morrison. 1998. The evolution of competition since deregulation.

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Economic model
Limited fixed number of seats C, two fares: high and low

aH > aL bH > bL
p

Monopoly pH = a H bH qH pL = aL bL qL
p aH

Oligopoly pH = a H bH qiH pL = aL bL qiL

i i

Low fare

High fare

aL aH 2

aL 2 aL 2bL aL bL

aH 2bH

aH bH

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Two fares: Monopoly vs Competition (2 airlines)

Monopoly
p
aH aL .5a H .5a L pH p pL aH / 3 aL / 3 p pH pL
Fare not offered

Competition
p
aH aL
Fare not offered

1 a H aL 2 bH

1 aL aH + 2 bL bH

2 a H aL 3 bH

2 a L aH + 3 b L bH

1 a j a j +C b j 1 2 qj = 1 1 bj + b j b j 1 a j a j +C 2 b j pj = aj 1 1 + b j b j

2 a j a j +C b j 1 3 qj = 1 1 2b j + b j b j 2 a j a j +C 3 b j pj = aj 1 1 + b j b j

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Competition leads to:

Average price - DECREASE

Low Fare Price Quantity Increase (usually) Decrease (usually)

High Fare Decrease Increase

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Multiple fares/Multiple airlines

p a1

I airlines indexed by i J fares indexed by j a1 > a2 > a3 > ... > a J b1 > b1 > b3 > ... > bJ

a2
a3 a4 a5

p p p p p

1 2 3 4 5

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Solution for Multiple Airlines/Multiple Fares

Find highest M such that : I M a j aM <C I + 1 j =1 b j Fares M through J are closed . I M 1 a j ak b +C 1 I + 1 k =1 k qj = M 1 1 I bj b k =1 k I M 1 a j ak b +C I + 1 k =1 k pj = aj M 1 1 b k =1 k

As degree of competition increases: Average price goes down Load factor goes up High fare prices go down Low fare prices may go up Price differences decrease Fewer low fares are open

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Summary
Competition affects revenue management! Competition is an important factor to consider When prices are fixed competition leads to Increase in high-fare seats and decrease in low-fare seats When prices are decision variables competition leads to Decrease in average prices BUT low fares may go up In both cases airlines focus MORE on high-fare seats under competition.
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