American Airlines Case Study In textbook, Managerial Economics: A Problem Solving Approach Chapter 24
In 1992, American Airlines (AA), the market share leader in the airline industry, announced a new pricing strategy—Value Pricing. AA believed Value Pricing would address customer complaints and help reverse operating
losses by stimulating demand, increasing market share, and reducing costs. American narrowed the number of possible fares from 500,000 to 70,000 by classifying each into one of four classes (first class, coach, discounted
7 and 21 day purchase) and began pricing based on flight length. These changes resulted in lower list prices for both business and leisure travelers.
According to AA, the purpose of Value Pricing was to create “simplicity, equity, and value” in its prices. By simplifying the pricing structure, AA was stabilizing price fluctuations as well as establishing a price floor. The new system set firm prices based on restrictions and miles flown and eliminated any corporate discount programs. Most importantly, American believed the new fare structure created through Value Pricing would increase volume on their
planes (raising load factors). AA believed Value Pricing would drive an increase in overall demand through its effort to stimulate travel and economic activity. American also believed these prices would allow AA to increase its
market share.
Question: Is this pricing program likely to be successful?
Answer: AA failed to anticipate its competitors’ reactions to this new pricing plan. Had Robert Crandall, the CEO of AA at the time, understood the lessons of game theory, a devastating industry price war might have been avoided. Instead, AA pushed forward with the plan, competitors responded aggressively, and industry profits plummeted. The Value Pricing initiative was abandoned within months of its launch. Instead, Crandall should have tried a strategy that was less easily mimicked by his rivals.
Assignment Instructions
Read “American Airlines” ; located in Chapter 24 of the textbook, Managerial Economics: A Problem Solving Approach. American Airlines announced a new pricing strategy that they believed would address concerns and benefit the company. Conduct further research on American Airlines value pricing.
Analyze American Airline structure and decision to implement value pricing and discuss the following (750-1,000 words):
- Discuss the decision behind American Airlines developing and implementing value pricing to gain more
market shares. - Evaluate the impact competitors and additional economic factors had on the results of the value pricing
strategy. - What factors contributed to the advantages and disadvantages of this new pricing strategy.
- Provide alternative recommendations to the value pricing strategy that would result in a different outcome when implementing the strategy.
Discuss the decision behind American Airlines developing and implementing value pricing to gain more market shares
American airline was the second largest airline in the United States in 1978 and by 1992 it became the largest airline in the United States. Between 1980 and 1990 the passenger volume for the American Airline grew by approximately 80% the largest growth the Airline ever registered. However, in 1991, the industry was engulfed by recession. This was due to the Gulf war that the tore the country and greatly affected the American economy. The American airline experienced a severe fall in demand and it is at this point that its CEO Robert L. Crandall introduced the value pricing strategy with an aim of gaining more market share.
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Robert Crandall, felt price was the major determinant of demand at that point when the American Airline was on the verge of collapsing. With respect to substantial consumer dissatisfaction and high prices, Robert Crandall implemented the value pricing strategy by dividing consumers into two categories; Business travelers and Leisure travelers. As a matter of fact, consumers expected two things, low prices and frequent services. Therefore by selling the right seats to the right customers, the company believed they would beat the competition and regain their market share (McCann, 2016).
While the profits made during the first year of adopting this strategy was insignificant as a result of the cost of new entry that involved advertisements, the company accrued profits and gained competitive advantage against other airlines. Additionally, it managed to make cost savings of twenty five million dollars per year. Today the American Airline is still the leading in the industry in terms of revenues and profits.
Evaluate the impact competitors and additional economic factors had on the results of the value pricing strategy. What factors contributed to the advantages and disadvantages of this new pricing strategy
Reduction of market share
The competitors of the American airline significantly impacted the results of the value pricing strategy by reducing the market share. In any competitive market, every member is competing for the market advantage. Other airlines having realized the move by the American airline to cut prices by adopting the value pricing strategy, they equally cut their prices but maintained their previous ways of operations.
Additionally, they improved their services and focused on customer engagement. This competition played an important role in reducing the market share of the American Airline. Again, it took the American Airline time to fully and successfully implement the value pricing strategy. Having suffered cost impacts as a result of adopting value pricing strategies, its competitors took advantage of that circumstance to sell their services.
Reduction in consumer spending
The additional economic factor that greatly affected the results of the value pricing strategy was the reduced consumer spending. As a result of the Gulf War, the economy was affected and circulation of money was significantly reduced. The prices of commodities went up and people had to change their consumption habits by reducing their spending. This reduced the market for the American Airline despite the significant reduction of flight charges.
The factor that led to the advantages of this strategy was the reduced pricing and categorizing of travelers. The reduced pricing attracted customers while the classification of travelers made it easier for travelers to make their choices on their preferred airlines. However, it is also important to understand that there are factors that resulted to disadvantages the American Airline underwent as a result of adopting the value pricing strategy. One of the factors was decline in the economy. The market share reduces as a result of reduced incentive to travel by customers.
Provide alternative recommendations to the value pricing strategy that would result in a different outcome when implementing the strategy
Time-based/ dynamic pricing
Dynamic pricing strategy can also be referred to as demand pricing. It is a pricing strategy businesses employ by setting flexible prices for their goods and services based on the market demands. This pricing strategy would be an alternative to the value pricing strategy given the economic circumstances that surrounded the American Airline. However, the results of implementing this strategy would be different in the sense that revenues and profits would vary depending on how much customers would be willing to pay and the level of demand. Value pricing strategy despite working on the basis of cutting pricing and increasing product differentiation, profits or revenues can be predetermined and maintained. Dynamic pricing on the other hand does not set fixed charges and therefore it is difficult to predict the revenues and profits as well as forecast on the future returns. In developing a pricing strategy, it is important to consider the competitor’s reactions because competitors may react aggressively and bring down your business.
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