Price Dispersion under Costly Capacity and Demand Uncertainty

This paper tests the empirical importance of the price dispersion predictions of the Prescott-Eden-Dana (PED) models. Equilibrium price dispersion is derived in a setting with costly capacity and demand uncertainty where different fares can be explained by the different selling probabilities. The PED models predict that a lower selling probability leads to a higher price. Moreover, this effect is larger in more competitive markets. Despite its applications to several important market phenomena, there exists little empirical evidence supporting the PED models, mostly because of the difficulty of coming up with an appropriate measure of the selling probabilities. Using a unique panel of U.S. airline fares and seat inventories, we find evidence that strongly supports both predictions of the models. After controlling for the effect of aggregate demand uncertainty on fares, we also obtain evidence of second degree price discrimination in the form of advance-purchase discounts.