price discrimination in the airline industry - Fagbokforlaget

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then choose the ‘right’ version. If so, the firm earns 2A + C. By damaging one version ofthe product the firm has increased its earning with C.Why has such a strategy been profitable for the firm? It does not earn more fromthe consumer with a low willingness to pay, despite the fact that the damaged version isment for that particular consumer. The point is that the consumer with the highwillingness to pay has a less attractive alternative. It implies that the firm can charge ahigher price on the high quality version, and still be sure that consumer 1 buys the highquality version.However, the firm can earn even more. We know that the consumer with a hightotal willingness to pay would value a marginal increase in quality higher than what is thecase for the consumer with the low total willingness to pay for the product. This isillustrated in Figure 1 with the fact that the marginal willingness to pay curve forconsumer 1 is to the North East of the marginal willingness to pay curve for consumer 2.The firm can exploit this by damaging the product even further. This is illustrated inFigure 2.Figure 2 Damaging product no. 2Marginalwillingnessto payB 1Consumer 1 demandConsumer 2 demandA 1Q 2Q 1B 2A 2CQ 3Quality© Steen and Sørgard 6
As shown in Figure 3, the quality on the damaged version equals Q 3 . It implies thatconsumer 2 is willing to pay A 1 for the damaged product. If the firm decides to offer sucha damaged product, it would lose revenues equal to A 2 from the sale to consumer 2. Onthe other hand, the damaged product is now less valuable for consumer 1. The alternativeto the high quality version is thus less attractive. The firm can therefore increase the priceof the high quality version and still be sure that consumer 1 chooses to buy the highquality version. It can easily be seen that the firm sets the price (slightly less than) A 1 +A 2 + B 2 + C. Consumer 1 will still choose the ‘right’ version.The total revenue for the firm is now 2A 1 + A 2 + B 2 + C. Comparing with Figure1, we see that the firm is better off if B 2 > A 2 , i.e., the increase in revenue from consumer1 outweighs the loss of revenue from consumer 2. This is true Figure 2. It can then easilybe shown that it will always be profitable for the firm to set quality below Q 2 for thedamaged product. How much product damaging that is profitable will depend on (i) thedifference in willingness to pay for quality for consumer 1 and 2, and (ii) the number ofconsumer sin each group. The latter effect is not taken into account in our model, sincewe assume that there is only one consumer of each type. However, it can easily be shownthat the degree of product damaging will increase in the number of consumers of type 1(the consumer with the high willingness to pay for quality).The analysis is very stylized, but it illustrates a firm’s incentives to damage aproduct. Note that the reason for damaging the product is not to tailor the quality to theconsumer with a low willingness to pay. The crucial point is that the consumer with highwillingness to pay has a less attractive alternative. The firm would choose to damage theproduct to such a degree than even the consumer with the low willingness to pay forquality is hurt. In such a perspective the product damaging can be regarded as severe.2.2 The welfare effects of versioningAs shown in the previous Section, versioning implies that one version of the product isdamaged. The consumer with a low willingness to pay is offered an inferior version. Atfirst sight this may seem detrimental to welfare. As we will see, this may not be true. Thecrucial question is: what is the alternative to versioning?© Steen and Sørgard 7
Page 1 and 2: PRICE DISCRIMINATIONINTHE AIRLINE I
Page 3 and 4: various kinds of price discriminati
Page 5: If the quality of the good equals Q
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

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