Randomization and price discrimination: The profitability of a mixed pricing strategy for airfares

In the airline industry, it is critical for carriers to vary prices offered to different customer groups in order to extract maximum willingness-to-pay from each consumer. This essay investigates a dynamic form of third-degree price discrimination in which prices are strategically adjusted as departure date approaches. It is hypothesized that by including a stochastic element in their pricing schemes, airlines can induce customers to self-select based upon their reservation prices, improving their profitability. Specifically, a mixed, randomized strategy in which expected price decreases over time may prompt risk-averse consumers with high reservation prices to purchase before customers with lesser reservation prices are offered a lower market price. Following this theoretical inquiry, an empirical examination reveals the possibility that such a pricing strategy is incorporated into pricing of airfares in the current market. Time series of flight data are studied, with a decomposition of fare prices into their systematic components revealing that an additional stochastic element may indeed be present.