A Model of Optimal Consumer Search and Price Discrimination in the Airline Industry

The welfare effects of price discrimination in the market for airfare can be ambiguous: price discrimination can increase airline revenue, but it can also allow for a more efficient allocation of tickets. This paper examines the market for airfare with a structural model of consumer search. My model features sophisticated consumers with rational beliefs about future price movements. Consumers in the market make optimal decisions based on their beliefs about future prices, search costs, and their probability of flying. I model beliefs about future prices as a Markov process based on flight characteristics and current prices. Using data on daily price and quantity in monopoly markets, I estimate the demand for airfare and calculate consumer welfare. I find that leisure travelers account for 70% of all air travel and are more prone to searching for tickets, an average of 2.48 times compared to 1.03 times for business travelers. I compare welfare in a counterfactual market in which airlines cannot price discriminate. The results show that without price discrimination, 5.01% fewer tickets are sold, and consumer welfare increases as a result of lower prices, less search and less cancelation fees.