Come Fly With Me -- At the Right Price

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New research from Michigan Ross Professor Jun Li shows how airlines should adjust to savvy price-shoppers.

ANN ARBOR, Mich. -- There are people who need something and buy it right away and those who look around more, maybe wait for a sale or a price reduction.

Technology and competition has made the second option easy with airline tickets. But how many people actually take advantage of this, and what kind of effect does this have on airline revenue?

These people are strategic consumers, and the focus of Michigan Ross Professor Jun Li’s new research. She’s found that while they are relatively small percentage of airline ticket-buyers, their habits can have a profound effect on revenue.

LiThe paper, “Are Consumers Strategic? Structural Estimation from the Air-Travel Industry,” sheds new light on both consumer behavior and how airlines should adjust their pricing strategy. Li’s co-authors are Nelson Granados of Pepperdine’s Graziadio School of Business and Management and Serguei Netessine of INSEAD in France. The research was published in the journal Management Science

“Information technology makes it so much easier for the consumer to learn about airline pricing strategy, and it gives companies the ability to use this data,” says Li, professor of technology and operations. “It’s really an opportunity for both sides in the market.”

Li’s analysis of airline fare and booking data showed that 5.2 percent to 19 percent of airline consumers are strategic, depending on the market. That is, they search for flights and wait to see if the price goes down. There’s some risk to this, because airlines adjust prices based on the demand they see. If demand falls, they often lower prices; if demand beats the forecast, the price won’t change or could rise.

Conventional wisdom suggests that more customers adopting this wait-and-see approach could be bad for the airlines, because it masks real demand.

But Li found that this strategic behavior isn’t so bad for the airlines. However, their price-making algorithms could use an update.

In the leisure travel market, airlines actually benefit from this strategic behavior because customers are price-sensitive and flexible. When customers wait on the purchase, find a lower price, and buy, it increases demand. If airlines adopt a non-decreasing price strategy in order to curb this behavior, they’ll lower demand and won’t be able to recoup the revenue from price increases.

Airlines are hurt more in the business travel market by the strategic behavior, because that market is less price-sensitive and less flexible. Strategic customers tend to drive down revenue through lower prices.

“The right strategy could help airlines increase revenue by 3-5 percent,” Li says. “That might not sound like much, but since airline costs are fixed, every bit of additional revenue helps the bottom line.”

Airline computer systems that adjust prices over time with demand don’t take this strategic behavior into account, Li says. They typically adjust prices at regular intervals based on demand.

Problem is, strategic consumers cross those set time intervals. Consumers are reacting to what the airlines do, and algorithms don’t account for it, she says.

“When I talked to people at airlines they said they are aware of this and are thinking about how to act on it,” Li says. “They need to see this as a game played between consumers and the company. So what’s the equilibrium? What’s the optimal strategy? We hope this research can start answering some of the questions.”

 

Media Contact: michiganrosspr@umich.edu