An airline's most important cost for pricing is the “opportunity cost” of its capacity. Incremental costs other than capacity costs (for example, food, ticketing) are literally trivial in comparison. An airline that took the historical cost or even the replacement cost of buying planes would miss many opportunities for profitable pricing and, in a competitive market, would soon go bankrupt because most of the profitability of an airline comes from the “incremental” revenue that it generates selling some seats at prices below the average cost per seat. The key to making such a strategy profitable is to understand on an ongoing basis the expected opportunity cost of selling a seat at any particular time on any particular flight.
What is the opportunity cost of a seat? On Saturday afternoon to non-resort locations, it is probably zero since there is no way that the plane will ever be filled. At most times, however, a plane could easily be filled by offering a low discount price during the month before the flight. The opportunity cost of selling such a seat is the contribution that could be earned from a full-fare passenger, usually a business traveler, times the probability that such a price-insensitive passenger will in fact buy the seat before the plane departs. For example, if a plane currently has empty seats one month before the flight, the airline uses historical booking patterns to estimate that it has a 70 percent probability that the plane will depart with at least one empty seat. That means that there is a 30 percent probability that a seat would not be available to a last-minute passenger willing to pay full fare. If the contribution from a full-fare ticket for the flight is $500, then the “opportunity cost” to sell a discount ticket in advance is 0.3 × $500 = $150, to which we add the cost of ticketing and incremental fuel, to estimate the total cost of offering the ticket. This costing system explains why the price of a discount ticket on the same flight might go up or down many weeks before a flight departs, while there are still many seats available. Airlines have sophisticated “yield management” systems that use historical booking patterns to estimate the probability of an empty seat at departure. If a plane is not filling up as rapidly as historically expected, the probability of an empty seat goes up, the opportunity cost of selling more discounted seats goes down, so the airline's management system may offer some tickets at an exceptionally low price. If, however, a group of seven businesspeople suddenly books the flight, the probability of filling the flight jumps substantially, the opportunity cost goes up, and the airline's yield management system automatically blocks additional sales of the cheapest tickets.