Abstract
In the airline industry, where information asymmetry prevails, airlines employ various strategies to maximise profitability. Signalling theory offers a valuable framework for understanding how airlines communicate the quality of their offerings to consumers through pricing signals. This theory suggests that signallers (airlines) use pricing to indicate the quality of their products or services to receivers (consumers), who then use these signals to inform their purchasing decisions (Connelly et al., 2011). Airlines often differentiate themselves by signalling through market share, pricing, and brand perception, with pricing being a particularly potent indicator of quality (Jeng, 2016; Jiang et al., 2014). Elevated prices for premium products can effectively signal superior quality, providing consumers with confidence in their more expensive purchasing choices (Bagwell, 1992).
Traditional economic theories suggest that a higher market share often acts as a quality signal, indicating to consumers that many others have favoured a company's products or services, thereby implying superior quality (Caminal & Vives, 1996). Bhattacharya et al. (2022) further empirically demonstrates that firms with higher market share can deliver more credible signals, enabling them to set higher prices and consequently enhance profitability.
This study enriches signalling theory by incorporating relative price, which reflects the price differences between products of varying quality. This pricing framework segments consumers and signals quality differences between service tiers. Hernandez (2011) contributes to this expanded understanding by demonstrating that competition influences pricing strategies. Their findings indicate that the optimal price ratio between products of varying quality levels widens with increased competition intensity. This suggests that in competitive markets, a larger price differential is used effectively to signal superior quality, offering a competitive advantage. However, the effectiveness of price signals is contingent on market structure. While price differentiation can reinforce consumer perceptions of quality, Basdeo et al. (2006) argue that when multiple firms engage in similar signalling strategies, the clarity of any single price signal may be diminished. In such cases, firms must establish sufficiently pronounced price differentiation to ensure their signals remain distinct and effective in influencing consumer perceptions.
This study bridges an empirical gap by employing the relative price to analyse how pricing strategies between business and economy classes serve as signals of quality and impact airline profitability. Relative price quantifies the deviation of business and economy class pricing of an airline from the average fare on specific routes, providing a nuanced measure of how airlines use price differentiation as a mechanism to convey service quality. At each airline level, relative price is a strategy characterised by setting higher business class fares to maximise revenue, while offering lower economy class fares to boost sales. As most routes offer two or three distinct quality tiers, such as business and economy class, this market structure is particularly well-suited for such an investigation. Furthermore, competitive routes represent high-demand market where multiple airlines with varying characteristics operate, while non-competitive routes tend to have lower demand. Consequently, the extent to which market share signals quality may vary across markets. It is more likely to reflect quality in competitive routes, while in less competitive markets, where consumer choice is limited, it may instead reflect a lack of alternatives rather than superior service. By analysing the impact of relative price signals on airline revenues across different market contexts using real-world airline data, this study contributes to signalling theory by exploring these dynamics in a practical, real-world setting.