How and Why Do Airlines Charge Different Prices For The Same Experience? An Introduction To Airline Pricing & Revenue Management

When you board a flight, very rarely do you actually pay the same price as the person sitting next to you onboard. The way airlines price flights is generally a great mystery to most people, with the systems that are behind it being unknown to most. What many might not know is that the way airlines determine the price you pay isn’t just a person typing random prices into a computer (though I doubt anyone actually thinks that), but there’s actually a very complex system behind your ticket fare. In this article, I will try and answer the following questions:

• Why do airlines charge multiple prices for the same product?
• How are airlines able to charge more for the same product?
• What are some of the qualities that airlines use to discriminate against customers?
• How can you predict airline revenue based on multiple fare classes?
• How does this fit into an airline’s larger route network?

Airlines charge different prices for the same experience largely to maximize revenue, as different types of people are willing to pay more or less for the same experience. While there’s a whole lot more to ticket pricing and revenue management than can be written in just one article (or one book, for that matter), I do hope to provide a base of understanding of the way airlines decide on what they charge the consumer.

Historical Background & Context

Back in the day before deregulation, the CAB would regulate airfares for specific routes, giving the airline little control over the way they price their flights. Just in case you thought that airlines were lobbying for deregulation, in fact they weren’t; the CAB nearly ensured airlines’ profitability, so many carriers were in fact against deregulation.

However, with airline deregulation in 1978, airlines gained much more freedom in the way they charge for flights, which generally led to significantly greater competition among routes and let to a near revolution in airfare pricing, first and foremost allowing the greater portion of the American population to fly, as tickets had been for the most part outrageously high pre-deregulation. Deregulation allowed airlines to have much more flexibility in how they charge for their flights, leading them to develop many more intricate ways to generate the most revenue. This of course is a massive generalization, though it isn’t an extensive evaluation of deregulation.

About at this time, other authorities, particularly in Europe, which had similar restrictions as the United States, started to deregulate the airline industry. Concurrently, shortly before and after deregulation, airlines started to find ways to increase revenue by working around the rules, which became significantly less stringent post-deregulation. For example, some airlines started to offer discounted tickets to certain consumers (I believe American Airlines was among the first).

However, the dawn of revenue management (which basically is how airlines–though it has spread much beyond just airlines–decide on different fares through the analyzation of markets, which is basically what this article is about) truly occurred back in 1972, when an executive for BOAC named Ken Littlewood came up with a strategy in pricing fares, later known as Littlewood’s Rule. Littlewood’s Rule in essence talks about a two-fare system and about how many seats in the lower fare class should be sold in order to maximize revenue, which later developed into Expected Marginal Seat Revenue. Anyway, I’ll explain more on revenue management later on in this article.

Why Do Airlines Charge Multiple Prices For The Same Experience?

While there are many factors that go into determining what you pay for your flight, such as competition and costs, in the rest of the article I’ll be mostly highlighting how and why airlines charge different prices for the same class on the same flight, and how it might increase or decrease. Just for some broad context, for a specific flight, airlines tend to offer multiple fare classes (such as Y, which generally is full class economy, or H, K, Q, L, other common economy fare class) in the same travel class (i.e. economy). Despite sometimes paying 3-4x as someone in a lower travel class, passengers in a higher or lower fare class in the same travel class receive a nearly identical experience onboard (with slight differences such as complimentary seat selection or baggage), which would qualify as price discrimination.

To answer the question above in the header, the reason why airlines charge different prices for different fare classes for (roughly) the same experience is quite self explanatory: it’s to increase revenue. Since the added marginal cost of one extra passenger onboard a flight is very minimal (most costs for flights are for fuel, landing fees, etc, which don’t change if there’s one less passenger), maximizing the number of passengers onboard, even if they pay very little (as long as a few pay much more), should very broadly result in increased profits. Of course, airlines don’t give away empty seats for nothing or for a dollar because there definitely are extra costs that a passenger adds (getting free flights from miles is different because airlines still earn money from that), it’s just that they are able to charge heavily discounted flights that still add extra revenue without increasing costs.

In fact, airlines have a whole little-known department dedicated to this: revenue management (formerly known across industries as yield management). The job of revenue management (RM) in essence is to look at market trends and decipher how many fare classes for a specific flight should be introduced and to decide how much they should charge for each of them in order to maximize revenue. This isn’t the only job of revenue management; they also decide what levels the airline should overbook flights in order to maximize (you guessed it!) revenue.

The cornerstone behind revenue management is that for a specific flight in a specific class, everyone is going to be willing to pay a different amount of money for a flight. The purpose of revenue management is to figure out what prices they set for each ticketing class, and how they can force different segments of the population willing to pay more, because as you can imagine, if you don’t have to pay more, very few will willingly pay the airline more than they have to.

You can also look at the why of how airlines charge more for the same product through a graphical standpoint that tends itself more towards basic economics. The first step in doing this would be to take a simple demand curve of a specific origin and destination combination. There is obviously no one demand curve that airlines can completely accurately discern, though they can get a sense of it. In this example, just for simplicity, I’ll use an exponential curve, though demand curves for different flights can obviously vary.

In this section, I’m going to use the example of a short-haul flight, say from Washington Dulles to Chicago O’Hare, which, just as an example, could have 150 seats for sale in economy class. For one flight, imagine a single fare scenario where an airline were to theoretically only offer one price, which would, over a long timespan, have an average amount of seats sold according to the demand curve. The area under the rectangle represents the revenue that an airline makes if they sell seats at that price. One would probably expect that demand curve to look something like this diagram below:

The revenue for selling only one fare at $160 would on average, in this example, sell 90 seats, making for a revenue of about $14,400 per flight. However, if you look at the graph and the demand curve, there will still be seats left empty for people who would be willing to pay a higher price, and there are plenty of people who will end up paying $160 who would be willing to pay more. From a graphical standpoint, revenue is the shaded area under the demand curve; with just this one price used, that leaves a whole lot of area underneath that is spoiled.

This leads airlines to charge more than one price for the same basic experience in economy class in order to maximize the total area. Hence, airlines generally charge more than one price per travel class, with a few generally aimed at high yield customers and others aimed at low yield customers. I will explain more on how airlines do this in the next section. If I were to add two more fares, one at $380, another at $80, the graph would look something like this:

As you can see, now the airline would expect to sell 40 seats at $380 if it were the only price sold, would sell 90 seats at $160 if it were the only fare sold, and would expect to sell 155 seats if all were sold at $80. By selling a certain number of seats at multiple separate fare values, as you can see via the graph, the average revenue earned will increase significantly. Now, the airline will earn $15,200 based on 40 seats sold at $380, $8,000 based on 50 seats sold at $160, and $5,200 based on 65 seats sold at $80. This will lead to a final average revenue of $28,000 for including three fare classes instead of $14,400 by just selling the one fare class.

However, the airline probably won’t sell out the entire plane at the lowest ticket price; that would probably result in some people who could pay more but don’t want to ending up paying less. This has to do with the fact that in a single cabin class, airlines generally sell the maximum amount possible of the highest fare class (i.e. if the plane had 100 economy class seats, they would have 100 full fare tickets up for sale), while they might only sell 60 discount seats and 30 deep discount seats. This is fairly intuitive and is because it would make no sense at all to sell less discount seats than possible, in the rare occasion that one person who would want to pay more for the same seat (for some reason, more on that later) but would be denied the ability to do so.

You may have noticed that in the graph above, the airline sold 155 seats in economy, instead of 150, the capacity of the cabin class. This would be because airlines generally tend to overbook flights, as there is a certain percentage of people who will on average cancel their flight, leading airlines to sell more seats than are actually available. However, there comes a point where the cost of selling more seats than available on average outweighs the benefits (in compensation), leading to the airline setting an overbooking limit.

I could go more in depth in this, but this article is already long; I hope that by looking at airline pricing through a graphical standpoint makes clear the rationale of why airlines charge multiple fares for the same experience. This analysis isn’t only used by the airline industry; it is also used by everything from hotels to sports venues.

How Airlines Differentiate Between Customers (Segmentation)

In the previous section, I talked about airlines segmenting customers into different groups; so in this section, I’ll discuss what groups they segment customers into and how they force various groups to pay more or allow others to pay less. Firstly, there are various segments of people who fly that have various different characteristics; some tend to be more willing to pay more and are therefore price inelastic, while others are very price elastic, meaning that they are very sensitive to price changes. Below are some common characteristics that airlines segment passengers into:

• High Yield Business Travel: High yield (meaning that they generally pay more) business traffic is usually the most profitable to airlines. High yield traffic is mainly made up of people who work for larger corporations and therefore don’t mind larger changes in price. Some may value comfort in order to be rested at their destination and ergo may pay for full fare business class, while others may be less senior or work for smaller companies which can’t afford business, but still may willing to pay more than your average consumer in order to get extra flight flexibility that is usually included in full fare economy class. Such customers also generally travel during weekdays and most often don’t stay over weekends, while they often plan such business trips last minute. Often times, they are also very loyal to one particular airline because they like racking up frequent flyer miles. Regarding COVID-19 and the future of the industry, many analysts believe that high yield business travel may be permanently diminished (because of Zoom), though others believe that video calls still can never replace the face to face interaction.
• Low Yield Business Travel: Not all business travelers are willing to pay dearly for their flight convenience; there is a large group of (generally) small business owners or employees who are much more price sensitive than people who work for large corporations. Such people will still value some level of convenience, book later than leisure travelers do, and still largely don’t stay as long as leisure or VFR passengers, though will place a significantly greater value on price than high yield business travelers do.
• Low Yield Leisure Travel: Most leisure travel is low-yield, meaning that most people who go on vacations are generally somewhat price sensitive. This segment would include your average middle class family traveling to Florida or the Caribbean for a family holiday, or someone traveling to London to sightsee. Generally, these travelers plan their trips months in advance and stay for semi-extended periods of time, a lot of times one week, in addition to being highly price sensitive. Additionally, many such passengers may decide to go somewhere else other than their desired destination if the price is too high, or may decide to not take a vacation at all or take a road trip to a local beach or resort.

• High Yield Leisure Travel: This is probably the smallest segment on this list, but there is a very existent market for high yield leisure travel, consistent of mostly upper class people traveling to (mostly upscale) leisure destinations. Such people generally are willing to pay for full fare business class or at least premium economy and are less price elastic. The example I like to use for this is people flying business class on a flight from San Francisco to Tahiti, and who will often stay at a suite at something like the Four Seasons Bora Bora.
• Casual Visiting Friends & Relatives (VFR): VFR travel can be split up into two main categories: urgent and non-urgent VFR travel, which have vastly different characteristics. The first would be non-urgent travel, which would include visiting your parents or grandparents. Such travelers are generally price elastic and in some ways resemble the low-yield leisure market, in that they often will take the airline with the cheapest fare (not taking into account loyalty), will plan the trip months in advance, and in some cases may opt to simply not take the trip or use other forms of transportation. However, this group makes up a great deal of people on long-haul flights, traveling to see family at the opposite side of the world (such as people flying from the US to India or China to visit family).
• Urgent VFR: The second group is urgent VFR, which, to provide an example, would be to visit a family member who is suddenly ill or to visit a funeral or birth. These trips are planned last minute and one would generally be willing to spend much more to visit an ailing family member than to visit a healthy one.

Of course this is a generalization and there is oftentimes some overlap between segments. Now that I’ve covered the different types of passengers and the prices that they are willing to pay, airlines have to figure out ways to get the people who are willing to pay more for the same seat to pay more. Obviously the easiest way to do so is to introduce multiple cabin classes (such as economy or business), though airlines go beyond that by introducing different fares for a cabin. Airlines have through the years introduced multiple fares in a single cabin class, sometimes with all or many being shown as being available, while oftentimes they only make them available to certain passengers that fulfill certain criteria.

For a particular flight, there might be over a dozen (sometimes even more) different fare classes for economy class, with network carriers generally having more complex fare structures than LCCs. What airlines have figured out is how to make sure that everyone pays the maximum that they’re willing to pay, without having customers pay less than they’re willing to and without losing too many customers who aren’t willing to pay the minimum price. This has resulted in segmentation, where airlines look at different characteristics of various segments in a market (the basics of this I just described above) and make sure that the consumer pays more for the same seat by introducing various perks (that don’t generally cost the airline much) or by limiting the dates in which a particular fare is available. I have compiled a list of some of these tactics below:

• Duration Of Time In Advance: Many if not most leisure travelers and VFR passengers book their travel relatively far in advance, while a significantly greater percentage of business travelers book at relatively short notice. For that reason, airlines often close down or increase prices for lower fare classes a short amount of time in advance to the flight, leaving only the higher fare class available a few days before the flight.
• Length Of Trip + Saturday Stay Requirement: Most business travelers travel only in the duration of a week and generally don’t stay over the weekend at their destination, while many leisure and VFR passengers do. Thusly, airlines often have a Saturday stay requirement, in which a lower fare class may require that you stay over one week at your destination and over the weekend. This requires business travelers (who may be willing to pay more but don’t necessarily want to) to purchase the higher fare and lets leisure travelers staying for a longer period of time to be able to pay less.

• One-Way Flights Vs Round-Trip: A common trend among legacy carriers is that one-way flights cost more than half of what a round-trip costs, and sometimes even cost more than the entire round-trip. One of the reasons for this is that they are often bought by business travelers who aren’t sure when they will return but are willing to pay more (because they usually are paid by their corporation). Meanwhile, leisure or VFR travelers book round-trip tickets because they usually go to just a singular destination and then return to their hometown.
• Peak Dates: Oftentimes, airlines will have peak dates or blackout dates when they don’t sell a lower fare class because the level of demand is higher than usual, resulting in airlines generally being able to charge more. Some examples of this may include Thanksgiving or Christmas peak travel dates, or may include the entire summer as opposed to late winter or fall, when airlines may charge less.
• Added Flexibility: Business travelers value flexibility in their ticket more so than leisure or VFR traffic, as their schedules are more variable and might be willing to pay more because of that. After all, in the long run, it makes more economical sense to pay more for a ticket if there’s only a 70 or 80% chance that you actually will travel for a meeting if you can fully refund or change it, than to throw out the money for that entire ticket. Consequently, some airlines offer added flexibility to higher fare classes, allowing passengers to refund their ticket or change it without penalization.
• FFP Benefits: Many US airlines have started selling basic economy fares which don’t earn air-miles and are very valuable to some of your more frequent flyers, many of whom work for large corporations that are willing to pay more. To many of these flyers with status, the frequent flyer program has enormous value and not earning miles for a certain flight can be a deal breaker, leading them to purchase a higher fare.
• Other Benefits: Higher fare economy class tickets generally have more perks than lower-tier economy class fares. These would include seat selection, checked baggage, hand luggage, in-flight meals, priority check-in, upgradability, etc. While in lower class fares, one can generally purchase these individual perks separately, some people may value all of the added perks of a higher fare ticket, and, perhaps in combination with another aspect (as mentioned above), may find that purchasing a full fare ticket may in fact be cheaper than purchasing a lower class ticket, when including the add-ons that they would subsequently purchase.

Through these tactics, taking into account certain market trends, airlines are usually able to force passengers who would be willing to pay more to purchase a higher fare class, without sacrificing lower yield demand.

How Much Can Airlines Expect To Make Based On Multiple Fares?

This section is probably the most nitty-gritty part of this article and relates back to the latter part of Section 2. Here I’ll loop back to Expected Marginal Seat Revenue (ESMR), which is a development of Littlewood’s Rule, which I talked briefly about above and basically considers a two fare class model, while EMSR incorporates a multi-class model. Essentially, EMSR is the most important part of Revenue Management, as it talks about how much revenue an airline can expect to make by selling multiple seats at certain prices.

To start, consider a standard bell curve, which is representative of the expected seats sold for a certain fare on a certain day. This makes sense logically, because there will be a mean value of seats sold at a certain fare over a large time span, and, as you move away from that value, the amount of times on average that that amount of seats is sold will decrease. Airlines can determine the required information based on a plethora of market data analysis. The graph of the bell curve would look something like this:

Now, if you were to take the negative integral of the curve (it’s not that important why in this format), you would find a function which would represent the average number of seats sold at a specific fare. If you were to multiply the average seats sold at the specific fare, you would end up with a function that gives you the expected revenue made for a specific fare, which would start asymptotically, where (generally) there would be a specific number of seats where the probability of them being sold is near 100% (the expected revenue there would be the actual fare cost), though as the number of seats being sold increases, the probability of that seat being sold at that fare will decrease until it asymptotically approaches zero.

I know this may not be the most comprehensive description, but if you were to layer these expected revenue graphs on top of each other for multiple fare classes, you would end up getting something that looks somewhat like this:

In my recurring example, there are three fares shown. For the first fare, Fare A, there is a roughly 100% chance that the first seat will be sold, though for each individual seat at that fare, the probability that the seat will be sold will decrease, until it reaches zero. Thus, the expected revenue for Fare A is the area under the green curve. Same with fares B and C, though since the fare costs less, there are many more seats where there is a nearly 100% chance of being sold, and hence the expected revenue graph stays level before it decreases for much longer.

In this model, the area under the curve represents the expected revenue of the airline for this one flight if there were three fares sold. The dotted vertical lines represent where the lines meet, and therefore represent where, for one specific number of seats sold, the average revenue made in the long term for that one specific seat will be the same for both fares. For example, Fares A & B will earn the same amount of money for the 40th seat sold in the long term, while Fares B and C earn the same for the 90th seat. Obviously, EMSR becomes a lot more complicated for airlines with larger route networks and different planes and more fare classes, but I think this covers the very basics of it.

My purpose in sharing this information is to show more visually why airlines have multiple fares. If the airline were only to sell prices at Fare A, the average revenue made per flight would only consist of the area under the green curve. Same thing if they sold only Fares B and C. Meanwhile, since the airline sells three different fares (and only puts on sale enough of the lower two fare classes that it won’t take away from people willing to pay more, along with using some of the other tactics listed above), the airline will earn the revenue represented by the area under the three curves, which makes it obvious why revenue management helps airlines earn so much more money than if they were only to sell seats at one price.

This also helps demonstrate that airlines don’t always make money selling flights, even if they are full. If an airline was selling flights only at fare C, they wouldn’t earn anywhere near the revenue than if they sold three different fares and used some of the tactics listed above to make people pay the most. So while a flight may be full, the airline may not actually be making any money off of that route, and while a flight may be empty, the route may be more profitable than you think it is at first glance.

Lastly, I also inserted an overbooking limit in my model, which is the limit of seats the airline is actually willing to sell, though that’s a topic for a whole other article.

Airline Prices In A Larger Route Network

In this final section, which I hope to keep short, I’m just going to quickly talk about how all of this fits into an airline’s broader route network. Most airlines today have larger route networks and offer connections, my point being that very few airlines only offer nonstop services where the model presented above works for most flights (the only two airlines that come to mind are Ryanair and Wizz Air).

A common phenomenon noticed by people such as myself who pay a lot of attention to airline prices is that airlines oftentimes charge more for a nonstop flight than a one or two stop flight, even if that nonstop flight that costs more is included in your itinerary. For an example, very often, an airline might offer a flight between City A and City B for a price (say $200) but would offer a ticket between City A and City C via City B for a lower price (say $150). This leads to practices such as hidden city ticketing, where a customer may book a flight from City A to City C via City B, but gets off at City B with no intentions of going to City C because of the higher price of the nonstop flight.

The practice of often pricing nonstop flights at a premium is due to airlines pricing flights not based on distance or as a combination of flights but between city pairs. This means that an airline looks at the a market of two city fares and decides, based on competing airlines and market research, what the consumer is willing to pay on average between those two cities. This results in airlines charging more between two cities that happen to have a nonstop flight between each other (i.e. because the consumer may be willing to pay more or there may be less competition), while between two cities that don’t happen two nonstop flights (in which the itinerary may include a flight that on its own costs more) the airline may be forced to have lower prices, resulting in this discrepancy.

Conclusion

Airline pricing is an extremely complex affair and obviously is a lot more intricate than I was able to cover in this brief introduction (though I do feel kind of weird calling this 5,000 word article a brief introduction). Airlines charge different prices for the same experience largely to maximize revenue, as different types of people are willing to pay more or less for the same experience. Segmentation is used by airlines to differentiate between distinct types of customers and to discover various characteristics of them in order to force some to pay more and allow others to pay less. Meanwhile, EMSR is one of the tactics used by airlines to model how much they can expect to earn from one flight with multiple fares. Lastly, airlines look at pricing throughout the entire network, resulting in some charging more for nonstop flights, as opposed to connecting flights.