price discrimination in the airline industry - Fagbokforlaget

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2.4 Frequent flyer programsFrequent flyer programs can be regarded as a quantity discount: by purchasing a certainamount of a good, it receives one unit of the good for free. In this Section we analyse thewelfare effect of such a particular price discrimination scheme. We start out by analyzingmonopoly, and then discuss how our conclusions may change when we have acompetitive setting. 7As a starting point, let us interpret a frequent flyer program as a discount program.The discount is not a price reduction as such, but a larger quantity offered for a givenprice. This is valuable for the consumer. The effects for the consumer are illustrated inFigure 7.Figure 7 The welfare effects of a frequent flyer program with monopolyPriceDemand with a frequent flyer programCP FFPp MONBADemand without afrequent flyerprogramQuantity7 The analysis we present here draws heavily on Steen and Sørgard (2001), chapter 7.© Steen and Sørgard 16
The solid line is the demand if there is no frequent flyer program. If we introduce afrequent flyer program, then the demand expands from the solid to the dotted line inFigure 7. One way to see this, is to consider the consumers’ willingness to pay. For agiven quantity, the consumers will have a higher willingness to pay. The reason is thatthe consumers now receive an additional amount, or more precisely an option on anadditional amount of the good in the future. Therefore, the demand curve shifts upward.An increase in the willingness to pay is of importance for the firm’s price setting.The firm can extract part of the increase in consumer surplus by increasing the price. Thisis illustrated in Figure 7 with the price increase from p MON to p FFP in Figure 7.What are the effects for the consumers of the introduction of a frequent flyerprogram? With no frequent flyer program the consumer surplus is A + B in Figure 7.From the Figure we see that after the introduction of the frequent flyer program theconsumers surplus is B + C. Then we see that the effect for the consumers of theintroduction of a frequent flyer program is ambiguous. On the one hand it has a higherwillingness to pay for the good, since it includes an option for a free unit in the future. Onthe other hand, the consumer is hurt by the price increase triggered by the introduction ofthe frequent flyer program. We see from Figure 7 that the consumers are worse off afterthe introduction of the frequent flyer program if A > C.The introduction of a frequent flyer program is analogous to an increase in qualityfor the good in question. As shown in Spence (1975), a quality increase has anambiguous effect on the consumer surplus. The basic reason is that the consumers careabout how a quality change affects the total willingness to pay, while the firm cares abouthow quality affects the marginal willingness to pay. There is no mechanism that canassure that those two effects coincide. Hence, there is no reason to expect that the marketoutcome leads to the quality level the consumers would prefer.The above analysis shows that from a consumer point of view the frequent flyerprogram has an ambiguous effect in monopoly. However, there are two important aspectsthat are left out of the analysis so far. First, the incentive structure for the consumers. Inthe industry in question we often observe that the person that buys the product is notpaying for the good. An employee buys the air ticket, while the employer pays the ticket.However, the frequent flyer program is an individual program. It implies that the© Steen and Sørgard 17
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 and 12: products. This would lead to an inc
Page 13 and 14: A price increase for the group with
Page 15: Even if third degree price discrimi
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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