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78 Chapter 3 Demand Analysis and Optimal Pricing

scores of fares, ranging from first-class roundtrip tickets at $2,400 and greater to discount tickets

below $250. On average, half the tickets sold for fares below $400, some 20 percent of tickets were

priced above $800, with the remainder priced in between. Some travelers cashed in frequent flier

miles. Some purchased at discounts from third-party providers; others received lower fares for

restricted tickets requiring Saturday stayovers. In general, early buyers paid less, but fares fluctuated

day-to-day depending on demand.

The question here is: How can demand analysis help the airlines win the game of yield

management?

In Chapter 2, we presented a simple model of profit maximization. There the

manager began with demand and cost functions and used them to determine

the profit-maximizing price and output level for a given product or service. In

this chapter, we will take a closer look at demand and the role it plays in man-

agerial decision making.

The notion of demand is much richer than the simple formulation given

in Chapter 2. For instance, up until now we have studied the dependence of

demand on a single factor: price. We begin this chapter by considering the

multipledeterminants of demand. Next, we look more closely at the respon-

siveness of demand to these factors, a concept captured in the basic definition

of elasticity.In the remaining sections, we present a richer formulation of

demand and show how it can be used to guide managers in their goal of max-

imizing profits. Toward this end, we will refine our optimization techniques to

account for more complicated demand conditions—those that include the pos-

sibilities of market segmentation and price discrimination.

DETERMINANTS OF DEMAND

The Demand Function

To illustrate the basic quantitative aspects of demand, let’s start with a concrete

example: the demand for air travel.^2 Put yourself in the position of a manager for

a leading regional airline. One of your specific responsibilities is to analyze the

state of travel demand for a nonstop route between Houston, Texas, and a rap-

idly growing city in Florida. Your airline flies one daily departure from each

city to the other (two flights in all) and faces a single competitor that offers

two daily flights from each city. Your task is complicated by the fact that the

number of travelers on your airline (and therefore the revenue your company

earns) has fluctuated considerably in the past three years. Reviewing this past

experience, you realize the main determinants of your airline’s traffic are your

own price and the price of your competitor. In addition, traffic between the two

(^2) We are not ready yet to analyze the complicated problem of setting multiple fares described in the
opening of this chapter. That must wait until the concluding section.
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