Selling Tickets as Options: Airline Price Dispersion with Limited Seat Capacity

This paper develops a theoretical model for the optimal design of airfare as options under capacity constraint to study the price dispersion in U.S airline industry. Monopoly seller uses a menu of refund contracts to sequentially screen heterogeneous travelers who purchase the tickets before travel uncertainty is fully resolved. Airline finds it optimal to sell fully refundable fares to high-value customer when capacity is limited and to sell partially refundable fare when seats are abundant. The change of capacity accounts for the distinct jumps of non-refundable fare and the variation of refundable fare over booking periods. The model predicts that the price dispersion might fluctuate and then diminish as the number of available seat shrinks. An original data, which contains both high-frequent price and seat availability information for differentiated fares, provides strong empirical evidence that the price gap experiences step-wise drops before diminishing as departure date nears.