price discrimination in the airline industry - Fagbokforlaget
price discrimination in the airline industry - Fagbokforlaget price discrimination in the airline industry - Fagbokforlaget
y the damaging of the product they buy. Is this effect of large importance in the airlineindustry? Note that the product damaging we have described are typically harmful for thebusiness segment, if they choose the ‘wrong’ version, but less harmful for those whoactually purchase the damaged version. For example, a Saturday night stay-overrestriction is probably not very harmful for a leisure traveler. If so, there is reason tobelieve that versioning improves welfare. Moreover, versioning seem to be even morewelfare improving in a competitive setting. The empirical studies indicate thatcompetition leads to larger discounts on restricted air tickets. Then output expands in theleisure segment, the most price elastic segment. It is then very likely that versioning leadsto an increase in total output. As shown above, an increase in total output would be anecessary condition for a welfare improvement.In the airline industry an increase in total output is related to frequency. Higherdemand means that the airline can find it profitable to offer more flights and thereby toincrease the frequency. If so, versioning has a positive externality. In the businesssegment, in particular, higher frequency is valuable since a typical business passengerwould benefit from a large choice of departure times.Given that the airlines needs a certain revenue to cover its fixed costs, such a pricestructure as we have described here is the most appropriate one seen from the society’spoint of view. The welfare loss due to price above marginal cost is at a minimum if theprice-cost margins are high in segments with price inelastic demand and low in segmentswith price elastic demand. This is exactly what we expect to observe in an environment inthe airline industry with versioning and competition.Discount to large consumers has an ambiguous effect on welfare, as was the casewith versioning. In a monopoly setting, the airline has incentives to set price-cost marginsso that they are high in segments with price inelastic demand and low in segments withprice elastic demand. In such a perspective it can be beneficial. However, competitionmay have negative welfare effects. As illustrated by the experience in the Norwegianairline industry, competition may lead to discounts in those segments with buying power.That would typically be some parts of the business segments, where the buyers are large.If so, the discounts are large in segments with inelastic demand. This is not an optimalway for the airlines to cover its fixed costs. Moreover, selective discount may lead to© Steen and Sørgard 24
very intense rivalry on prices. The reason is that a Bertrand-like competition is triggered.Such a kind of price discrimination may therefore lead to exits from the market, becausenot all the airlines are able to cover their fixed costs. In a similar manner, potentialentrants might be deterred by the potential for selective discounts. It knows that theestablished airline is able to challenge it by offering selective discounts to largeconsumers. Since these discounts are secret and therefore more difficult to detect forcompetition authorities, such a kind of price discrimination may make predation a morecredible threat. This suggests that discounts to large consumers are anticompetitive in asetting with a potential entrant that may challenge the established airline. In our view,discounts to large consumers should be banned in a market situation where there is onelarge dominant carrier.Frequent flyer programs have an ambiguous effect on consumer surplus in asituation with only one airline. However, such a program has no doubt anticompetitiveeffects in a setting with more than one airline or a setting with one established airline andone potential entrant. This is predicted from theory, and those few empirical studies weare aware of give support to such a prediction. From a welfare point of view it is thenobvious that such programs should be banned. Note, though, that a partial ban of frequentflyer programs will hurt those firms that are not allowed to have frequent flyer programsmore than other airlines. From a domestic perspective a ban on our domestic airline’sfrequent flyer program can then hurt our domestic airline. However, even a partial ban isexpected to lead to more rivalry on prices. The airline facing a ban on its frequent flyerprogram must respond, and one response is to cut prices. The domestic consumers willtherefore be better off, even with a partial ban.4. SUMMARY AND CONCLUDING REMARKSCasual observations suggest that the airline industry practices price discrimination. Thepurpose of this report has been to discuss the welfare effect of price discrimination in theairline industry. We distinguish between three different forms of price discrimination: (i)versioning, (ii) discounts to large consumers, and (iii) frequent flyer programs. For eachof them we present what theory predicts, and then relate the results from the analysis tothe airline industry.© Steen and Sørgard 25
- 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 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: city pair market and the importance
- Page 27 and 28: When airlines compete, there might
- Page 29 and 30: Holmes, T. J. (1989): ‘The Effect
very <strong>in</strong>tense rivalry on <strong>price</strong>s. The reason is that a Bertrand-like competition is triggered.Such a k<strong>in</strong>d of <strong>price</strong> <strong>discrim<strong>in</strong>ation</strong> may <strong>the</strong>refore lead to exits from <strong>the</strong> market, becausenot all <strong>the</strong> airl<strong>in</strong>es are able to cover <strong>the</strong>ir fixed costs. In a similar manner, potentialentrants might be deterred by <strong>the</strong> potential for selective discounts. It knows that <strong>the</strong>established airl<strong>in</strong>e is able to challenge it by offer<strong>in</strong>g selective discounts to largeconsumers. S<strong>in</strong>ce <strong>the</strong>se discounts are secret and <strong>the</strong>refore more difficult to detect forcompetition authorities, such a k<strong>in</strong>d of <strong>price</strong> <strong>discrim<strong>in</strong>ation</strong> may make predation a morecredible threat. This suggests that discounts to large consumers are anticompetitive <strong>in</strong> asett<strong>in</strong>g with a potential entrant that may challenge <strong>the</strong> established airl<strong>in</strong>e. In our view,discounts to large consumers should be banned <strong>in</strong> a market situation where <strong>the</strong>re is onelarge dom<strong>in</strong>ant carrier.Frequent flyer programs have an ambiguous effect on consumer surplus <strong>in</strong> asituation with only one airl<strong>in</strong>e. However, such a program has no doubt anticompetitiveeffects <strong>in</strong> a sett<strong>in</strong>g with more than one airl<strong>in</strong>e or a sett<strong>in</strong>g with one established airl<strong>in</strong>e andone potential entrant. This is predicted from <strong>the</strong>ory, and those few empirical studies weare aware of give support to such a prediction. From a welfare po<strong>in</strong>t of view it is <strong>the</strong>nobvious that such programs should be banned. Note, though, that a partial ban of frequentflyer programs will hurt those firms that are not allowed to have frequent flyer programsmore than o<strong>the</strong>r airl<strong>in</strong>es. From a domestic perspective a ban on our domestic airl<strong>in</strong>e’sfrequent flyer program can <strong>the</strong>n hurt our domestic airl<strong>in</strong>e. However, even a partial ban isexpected to lead to more rivalry on <strong>price</strong>s. The airl<strong>in</strong>e fac<strong>in</strong>g a ban on its frequent flyerprogram must respond, and one response is to cut <strong>price</strong>s. The domestic consumers will<strong>the</strong>refore be better off, even with a partial ban.4. SUMMARY AND CONCLUDING REMARKSCasual observations suggest that <strong>the</strong> airl<strong>in</strong>e <strong>in</strong>dustry practices <strong>price</strong> <strong>discrim<strong>in</strong>ation</strong>. Thepurpose of this report has been to discuss <strong>the</strong> welfare effect of <strong>price</strong> <strong>discrim<strong>in</strong>ation</strong> <strong>in</strong> <strong>the</strong>airl<strong>in</strong>e <strong>in</strong>dustry. We dist<strong>in</strong>guish between three different forms of <strong>price</strong> <strong>discrim<strong>in</strong>ation</strong>: (i)version<strong>in</strong>g, (ii) discounts to large consumers, and (iii) frequent flyer programs. For eachof <strong>the</strong>m we present what <strong>the</strong>ory predicts, and <strong>the</strong>n relate <strong>the</strong> results from <strong>the</strong> analysis to<strong>the</strong> airl<strong>in</strong>e <strong>in</strong>dustry.© Steen and Sørgard 25
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