price discrimination in the airline industry - Fagbokforlaget
price discrimination in the airline industry - Fagbokforlaget price discrimination in the airline industry - Fagbokforlaget
cases we start out by discussing monopoly, and then we extend the analysis to anoligopolistic setting.2.1 The motives for versioning 2Let us for the moment consider a situation with only one firm. To simplify further, weassume that there are only two consumers. Each of them demands one unit. Thewillingness to pay for each of them for this unit depends on the quality of the good. Torelate the setting to the airline industry, we may denote consumer 1 a business passengerand consumer 2 a leisure passenger. In Figure 1 we have illustrated the marginalwillingness to pay for each of the consumers for different levels of the quality of thegood.Figure 1Quality versus marginal willingness to payMarginalwillingness topayBConsumer 1 demandConsumer 2 demandAQ 2CQ 1QualityThe area below the marginal-willingness-to-pay curve denotes the total willingness topay. If quality is Q 1 (or higher), then consumer 1 is willing to pay A+B+C for the good.2 The model we present here draws heavily on Varian (2000). For other models of versioning, seeDeneckere and McAfee (1996) and Foros, Jensen and Sand (2001).© Steen and Sørgard 4
If the quality of the good equals Q 2 , then consumer 1 is willing to pay A+B whileconsumer 2 is willing to pay A.We assume that it is not more costly to produce a high quality than a low qualityproduct. As we will explain later, typically the low quality version is a damaged versionof the high quality version (called damaging product). If so, it is not obvious that the highquality version is the most costly one to produce.If we assume that there are no costs associated with producing a high qualityinstead of a low quality version, what then would the firm do? It would then produce aversion with high quality, which in Figure 1 is quality Q 1 , and sell it at a price of A toconsumer 2 and A+B+C to consumer 1. Then the firm would extract all potentialconsumer surplus, and it would earn 2A+B+C.But it is obvious that this is unrealistic. If the consumers can choose, then bothconsumers would of course buy the low price version. Then the firm would earn only 2A.As argued, the consumer supposed to buy the high price product buys the lowprice product. The low price product cannibalizes the earnings from the most valuablemarket segment. How could the firm avoid such a cannibalization? One possible solutionis, as indicated above, product damaging. Let us assume that the high quality version(quality Q 1 ) is still produced. Furthermore, let us assume that the quality of the secondversion equals Q 2 , and thus can be considered as a damaged product. This implies thatconsumer 2 still has a willingness to pay equal to A for the damaged version. Consumer1, on the other hand, has a higher willingness to pay for quality. He is willing to pay A+Bfor the damaged version.What if the firm now sets price A on the damaged good? Then it extracts allpotential consumer surplus from consumer 2. If so, which price should it set on the highquality version? Consumer 1 has a high willingness to pay, so the firm would prefer thathe buys the high quality version. But what is the maximum price the firm can charge onthe high quality version? If consumer 1 buys the damaged product, it pays A and receivesa consumer surplus equal to B. Then the firm must set a price on the high quality productso that consumer 1 receives at least B in consumer surplus. We see from Figure 1 that thefirm can charge (slightly less than) A+C for the high quality product, and consumer 1 will© Steen and Sørgard 5
- Page 1 and 2: PRICE DISCRIMINATIONINTHE AIRLINE I
- Page 3: various kinds of price discriminati
- 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 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
If <strong>the</strong> quality of <strong>the</strong> good equals Q 2 , <strong>the</strong>n consumer 1 is will<strong>in</strong>g to pay A+B whileconsumer 2 is will<strong>in</strong>g to pay A.We assume that it is not more costly to produce a high quality than a low qualityproduct. As we will expla<strong>in</strong> later, typically <strong>the</strong> low quality version is a damaged versionof <strong>the</strong> high quality version (called damag<strong>in</strong>g product). If so, it is not obvious that <strong>the</strong> highquality version is <strong>the</strong> most costly one to produce.If we assume that <strong>the</strong>re are no costs associated with produc<strong>in</strong>g a high quality<strong>in</strong>stead of a low quality version, what <strong>the</strong>n would <strong>the</strong> firm do? It would <strong>the</strong>n produce aversion with high quality, which <strong>in</strong> Figure 1 is quality Q 1 , and sell it at a <strong>price</strong> of A toconsumer 2 and A+B+C to consumer 1. Then <strong>the</strong> firm would extract all potentialconsumer surplus, and it would earn 2A+B+C.But it is obvious that this is unrealistic. If <strong>the</strong> consumers can choose, <strong>the</strong>n bothconsumers would of course buy <strong>the</strong> low <strong>price</strong> version. Then <strong>the</strong> firm would earn only 2A.As argued, <strong>the</strong> consumer supposed to buy <strong>the</strong> high <strong>price</strong> product buys <strong>the</strong> low<strong>price</strong> product. The low <strong>price</strong> product cannibalizes <strong>the</strong> earn<strong>in</strong>gs from <strong>the</strong> most valuablemarket segment. How could <strong>the</strong> firm avoid such a cannibalization? One possible solutionis, as <strong>in</strong>dicated above, product damag<strong>in</strong>g. Let us assume that <strong>the</strong> high quality version(quality Q 1 ) is still produced. Fur<strong>the</strong>rmore, let us assume that <strong>the</strong> quality of <strong>the</strong> secondversion equals Q 2 , and thus can be considered as a damaged product. This implies thatconsumer 2 still has a will<strong>in</strong>gness to pay equal to A for <strong>the</strong> damaged version. Consumer1, on <strong>the</strong> o<strong>the</strong>r hand, has a higher will<strong>in</strong>gness to pay for quality. He is will<strong>in</strong>g to pay A+Bfor <strong>the</strong> damaged version.What if <strong>the</strong> firm now sets <strong>price</strong> A on <strong>the</strong> damaged good? Then it extracts allpotential consumer surplus from consumer 2. If so, which <strong>price</strong> should it set on <strong>the</strong> highquality version? Consumer 1 has a high will<strong>in</strong>gness to pay, so <strong>the</strong> firm would prefer tha<strong>the</strong> buys <strong>the</strong> high quality version. But what is <strong>the</strong> maximum <strong>price</strong> <strong>the</strong> firm can charge on<strong>the</strong> high quality version? If consumer 1 buys <strong>the</strong> damaged product, it pays A and receivesa consumer surplus equal to B. Then <strong>the</strong> firm must set a <strong>price</strong> on <strong>the</strong> high quality productso that consumer 1 receives at least B <strong>in</strong> consumer surplus. We see from Figure 1 that <strong>the</strong>firm can charge (slightly less than) A+C for <strong>the</strong> high quality product, and consumer 1 will© Steen and Sørgard 5
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