One of the longer-term trends in the airline industry has been towards cheaper airfares. As we can see from Figure 3.1, between 1995 and 2019 inflation adjusted average airfares in the US market have fallen by nearly a third. The second quarter of 2020 (the first full quarter of the pandemic and the latest for which the data are available at the time of writing) saw average airfares drop by $100 (or over 25 per cent) in real terms as compared to the same quarter of 2019, reflecting precipitous fall in demand for air travel.

The other well-known feature of airline pricing is that airfares tend to be very dispersed. In an earlier study, Borenstein and Rose demonstrated that fares paid by two randomly selected passengers on a flight will be on average about 30 per cent apart (Borenstein & Rose 1994).

So, how do airlines come up with those fares? Why do prices change so often? Will I necessarily pay less if I book well in advance? Has the passenger sitting next to me paid more or less than I did? How can a flight be “overbooked” – is the airline not aware of how many seats there are on its planes? Why can't I get a refund if I am unable to travel? These are questions I suspect we’ve all asked ourselves. In this chapter, I will try to provide some answers, and more generally explain how an airline sets its prices.

The pricing system used by airlines is complex. This complexity is driven by the characteristics of the product the airlines sell, the heterogeneity of the airline's customers (i.e., leisure versus business travellers), and the need to fill up as many seats as possible to take advantage of economies of traffic density. Recall that the concept of economies of traffic density refers to the fact that per passenger costs are lowest when the flight is full. The pricing systems used by airlines are known as yield management (YM) or revenue management (RM) systems. Throughout this chapter, I will be using these names and acronyms interchangeably.