price discrimination in the airline industry - Fagbokforlaget

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a large supply of the low-quality version, and thereby lead to an increase in total supply.If this is correct, we should be even more liberal concerning such price discrimination ina competitive setting than in a setting with only one dominant firm.So far we have not said anything about whether the price reduction is largest inthe high quality or the low quality segment. This is mainly an empirical question.However, those few theoretical studies that raise this issue indicate that pricediscrimination may increase as the market become more competitive. 4 If so, this furtherstrengthen our conclusion that versioning in a competitive setting is especially importantfor the consumers with a low willingness to pay, since they will gain from low prices insuch a setting.2.4 Discounts to large firmsIn some of the airline markets we observe special arrangements for large consumers. Oneexample is ‘storkundeavtaler’ (‘agreements with large firms’) in the Norwegian airlineindustry. Many firms that demand airline tickets write a contract with an airline company.It typically implies that all the employees in that particular firm are given a specificdiscount on each airline ticket they purchase.These kinds of agreements are examples of third degree price discrimination. 5 Letus first discuss the effect of third degree price discrimination in a monopoly setting, andthen comment on the case with competition.In a monopoly, the firm will be better off by practicing third degree pricediscrimination. It enables the firm to exploit the group of consumers with a price inelasticdemand by charging them a high price, and then set a rather low price to the group ofconsumers with a price elastic demand and spur their demand. For society at large,though, this may reduce welfare. The reason is that the loss of consumer surplus for thegroup with a price inelastic demand may outweigh the gain in consumer surplus for thegroup of consumers with a price elastic demand. This is illustrated in Figure 5.4 See Borenstein (1985), Holmes (1989), and Gale (1993). In the latter model, for example, there is moreprice discrimination in duopoly than in monopoly.5 According to the definition in Varian (1989), third degree price discrimination means that differentconsumers are charged different prices, but each consumer pays a constant amount for each unit of thegood bought.© Steen and Sørgard 12
A price increase for the group with price inelastic demand results in an increase inthe dead weight loss, marked with the red (dark) shaded area, while the price decrease forthe other group of consumers results in a reduction in the dead weight loss, marked withthe blue (light) shaded area. In the literature it has been shown that a necessary conditionfor welfare to increase is that total output increase. 6 However, in many cases thesufficiency condition for welfare improvement is not met. For example, with lineardemand functions third degree price discrimination is not welfare improving (see Varian,1989, Section 2.4.1).Figure 5 Welfare effects of third degree price discrimination in monopolyPricePriceP 1Welfare lossWelfare gainP 0P 2PRICE INELASTIC CONSUMERS PRICE ELASTIC CONSUMERSMarg. costQuantityQuantityThe crucial question, then, is whether third degree price discrimination implies that somenew groups of consumers are being served. For example, a group of price elasticconsumers may not be served at all in a regime with one uniform price. The monopolyfirm may find it more profitable to serve only the price inelastic consumers. If price6 See Varian (1989), Section 2.4.1. It is shown that the sufficient condition for a welfare improvement is thatthe sum of the weighted output changes is positive, with the weights being given by the price-cost margin.© Steen and Sørgard 13
Page 1 and 2: PRICE DISCRIMINATIONINTHE AIRLINE I
Page 3 and 4: various kinds of price discriminati
Page 5 and 6: If the quality of the good equals Q
Page 7 and 8: As shown in Figure 3, the quality o
Page 9 and 10: consumers’ consumer surplus. Rear
Page 11: products. This would lead to an inc
Page 15 and 16: Even if third degree price discrimi
Page 17 and 18: The solid line is the demand if the
Page 19 and 20: 3. THE AIRLINE INDUSTRYIn the previ
Page 21 and 22: flexible air ticket, labeled C-clas
Page 23 and 24: city pair market and the importance
Page 25 and 26: very intense rivalry on prices. The
Page 27 and 28: When airlines compete, there might
Page 29 and 30: Holmes, T. J. (1989): ‘The Effect

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