Price Discrimination and Business-Cycle Risk

A parsimonious theoretical model of second degree price discrimination suggests that the business cycle will affect the degree to which firms are able to price discriminate between different consumer types. We analyze price dispersion in the airline industry to assess how price discrimination can expose airlines to aggregate- demand fluctuations. Performing a panel analysis on 17 years of data covering two business cycles, we find that price dispersion is highly pro-cyclical. Estimates show that a rise in the output gap of one percentage point is associated with a 1.9 percent increase in the interquartile range of the price distribution in a market. These results suggest that markups move pro-cyclically in the airline industry, such that during booms in the cycle, firms can significantly raise the markup charged to those with a high willingness-to-pay. The analysis suggests that this impact on firms' ability to price discriminate results in additional profit risk, over and above the risk that comes from variations in cost.