In the airline space, price segmentation can allow more customers to get what they value while the airline maximizes revenue. That’s because price segmentation allows an airline to more closely approximate the reservation price of a customer, and customers have reservation prices that differ from one another. A couple of key terms:

Reservation Price: the highest price that a customer is willing to pay for an offer. We use this concept in pricing models by assuming that a customer will pay any price less than or equal to the Reservation Price for an offer, and will not accept any price above the Reservation Price.

Price Segmentation: the practice of setting different prices for customers within different groups when presenting the same offer.  Economists call this “price discrimination.”

Proof:

Here’s a very simple proof. Three customers consider the same offer. Each customer has a different reservation price from the other two. In figure 1, the airline offers these customers a revenue-maximizing price of $30. In figure 2, the airline presents the same offer to the same customers as in figure 1, but at a price that matches each customer’s Reservation Price.

Figure 1:

	Reservation Price	Offer Price	Does Customer Buy?	Revenue	Customer Outcome
Customer 1	$40	$30	Yes	$30	Satisfied
Customer 2	$30	$30	Yes	$30	Satisfied
Customer 3	$10	$30	No	$0	Not satisfied
Total:				$60	2/3 satisfied

Figure 2:

	Reservation Price	Offer Price	Does Customer Buy?	Revenue	Customer Outcome
Customer 1	$40	$40	Yes	$40	Satisfied
Customer 2	$30	$30	Yes	$30	Satisfied
Customer 3	$10	$10	Yes	$10	Satisfied
Total:				$80	3/3 satisfied

In figure 1, the airline has presented the offer at the revenue-maximizing single price of $30, satisfying 2 of the 3 customers for whom the price was at or below their respective Reservation Price. If the airline increased that price to $40, revenue would decrease to $40 and satisfaction would decrease to 1 of the 3 customers. If the airline decreased the price to $10, revenue would decrease by half to $30, although satisfaction would increase to 3 of 3.

However, in figure 2, the airline presented the offer to each customer at their respective Reservation Price. The airline’s revenue is 30% higher and 3 of 3 customers are satisfied.

Price segmentation serves to simultaneously benefit the airline and each of the customers.

 

“You can’t charge different people different amounts!”

Actually, you can. It’s legal, possible, and accepted.

The following exchange actually happened:

Economist on stage: “Using price segmentation can maximize revenue and customer satisfaction.”

Audience member: “You can’t charge different people different amounts! It’s not legal in my country!”

Economist: [pause] “May I ask what you do professionally?”

Audience member: “I’ve been in airline RM for 30 years.”

Economist: “Ah, then are you a fugitive from justice? Because for 30 years, you’ve been charging different people different amounts to sit next to one another on an airplane.”

Airline RM is generally cited first when an economist talks about price segmentation. Because airlines charge people different amounts for the same flight. But there are many more examples in marketing, like student, OAP, or military personnel pricing at a movie theatre, school tuition based on family income, insurance prices (rates) based on age and postal code, ski lift tickets sold at a lower price in town than on the slope, and coupons sent to select customers in the mail.

The mistake some people make is in associating the practice in general with a few specific applications that are quite rightly illegal. Generally, firms may not use a customer’s status in a protected class as a basis of charging the customer more than the prevailing price. Examples may be to charge a person more because that person is a member of a minority race. It’s not all that easy to think of a time an airline would have a reason to even consider using protected class as a basis to charge more, but no airline ever should, regardless.

Determination of Reservation Prices isn’t easy, but the logical first step — per the proof above– is for an airline to group customers effectively. When that’s done, the airline might use A/B price testing within a group to determine an approximate reservation price. An airline might also consider the use of conjoint analysis to allow customers to provide their responses to prices of offers in context.

In his book Misbehaving: The Making of Behavioral Economics, Nobel-prize winning University of Chicago economist Richard Thaler presents conditions under which people generally find price segmentation to be acceptable.

To paraphrase and adapt to our industry, when presenting offers:

1. Price variations should be presented as “discounts” from the highest possible price, and
2. Price variations should be explicable.

An example might be movie theatre tickets, as previously mentioned. An adult informed at the box office that they must pay a $4 surcharge on a $10 ticket because they are middle-aged will be unhappy, whereas that same adult accepts that students and OAP receive a $4 discount on a $14 ticket. Each is simply a different way of expressing the exact same price segmentation.

For airlines, it’s not always necessary to display a full menu of prices available to any specific customer. Regardless, it’s worth considering these two considerations when designing price segmentation.

Conclusion

Price segmentation can allow more customers to get what they value while the airline maximizes revenue. The practice is commonplace all around us, and even in our own airlines’ RM departments. Still, an airline looking to improve their customers’ satisfaction and their revenue through price segmentation would be wise to consider legal constraints and customer perception, and structure varied prices as explicable discounts.