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 seventeen years of data covering two business cycles, we find that price dispersion is highly procyclical. Estimates show that a rise in the output gap of 1 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 procyclically 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.