price discrimination in the airline industry - Fagbokforlaget
price discrimination in the airline industry - Fagbokforlaget price discrimination in the airline industry - Fagbokforlaget
The alternative to versioning is no versioning. In our setting no versioning impliesthat one instead of two versions is supplied. Since there are two different consumers, thefirm may either serve only one of them or serve both.If the firm serves only one of them, it is obvious that it would serve consumer 1 –the one with the highest willingness to pay. Then it would set quality equal to Q 1 and seta price equal to A+B+C. The firm would extract all potential consumer surplus and earnA+B+C, which equals total welfare in this regime. If we compare with versioning, it isobvious that versioning would improve welfare. Consumer 1 will still be served, and thehigh quality version generates welfare (consumer surplus plus profits) equal to A+B+C,as is the case with no versioning. But, in addition, the consumer with the low willingnessto pay buys the damaged product at a price A 1 . This adds to the welfare generated by thehigh quality product, and versioning will therefore always increase welfare.If the firm serves both consumers in the case with no versioning, the welfareeffect of versioning is more complicated. To illustrate this, let us take into account thatthe number of consumers can differ between segments. So far we have only consideredtwo consumers, consumer 1 and 2. Let us now assume that there are several consumers oftype 1 and several of type 2. In particular, we assume that a fraction γ of the consumersare of type 1 (and thereby a fraction (1- γ) is of type 2).Which quality would the firm choose if it sells only one version and serves bothtypes of consumers? As argued in association with Figure 1, there is no additionalrevenue it can earn if it sets quality higher than Q 2 . As long as the cost of quality ispositive, even if it is infinitesimal small, the firm sets quality Q 2 . If so, the total surpluswith no versioning equals A + γB, where the firm earns A and the type 1 consumers has aconsumers surplus equal to γB. Then we must compare this total surplus with the totalsurplus generated with versioning. We have that versioning will increase welfare if:(1 – γ)A 1 + γ(A 1 + A 2 + B 2 + C) + γB 1 > A + γBThe first and second expressions on the left hand side are the profits earned on consumertypes 2 and 1, respectively, while the third expression on the left hand side is type 1© Steen and Sørgard 8
consumers’ consumer surplus. Rearranging, we have that versioning will increase welfareif:γC > (1 - γ)A 2The left hand side is the additional surplus generated by offering a high quality version(Q 1 instead of Q 2 ), while the right hand side is the loss of consumer surplus for the type 2consumers.From the above expression we can see what would be of importance for whetherversioning is welfare improving or not. There are three factors that may lead to welfareimproving versioning: (i) the fraction of the consumers with high willingness to pay(consumers of type 1) is large, (ii) their valuation of extra quality is high, and (iii) theother group’s valuation of quality degradation is limited.Although one could get a rough indication of the magnitude of these three factorsin a particular market, how could one decide whether versioning is welfare improving ornot? Following Varian (1996), we should focus on whether versioning leads to anincrease in total output. If versioning implies that some groups are served that else wouldnot have been served, versioning is expected to lead to higher welfare.2.3 Versioning and competitionSo far we have only considered a monopoly situation. What if there is more than one firmin the market? It is difficult to give a general answer to such a question, because itdepends on the toughness of price competition. In the literature is has been shown thatprice discrimination may collapse in such a setting. 3 Each firm has incentive to undercutthe rival’s price schedule. If so, this may lead to price equal to marginal costs and what islabeled the Bertrand paradox in the literature. It is a paradox, because we seldomexperience that kind of fierce competition on prices that theory predicts. Casualobservation indicates that in the airline industry we do not observe price equal tomarginal costs. On the other hand, we do observe that each airline offers differentversions of its air ticket even in a setting where airlines compete. This clearly shows that3 See, for example, Mandy (1992).© Steen and Sørgard 9
- Page 1 and 2: PRICE DISCRIMINATIONINTHE AIRLINE I
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- Page 11 and 12: products. This would lead to an inc
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- Page 21 and 22: flexible air ticket, labeled C-clas
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- Page 25 and 26: very intense rivalry on prices. The
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- Page 29 and 30: Holmes, T. J. (1989): ‘The Effect
The alternative to version<strong>in</strong>g is no version<strong>in</strong>g. In our sett<strong>in</strong>g no version<strong>in</strong>g impliesthat one <strong>in</strong>stead of two versions is supplied. S<strong>in</strong>ce <strong>the</strong>re are two different consumers, <strong>the</strong>firm may ei<strong>the</strong>r serve only one of <strong>the</strong>m or serve both.If <strong>the</strong> firm serves only one of <strong>the</strong>m, it is obvious that it would serve consumer 1 –<strong>the</strong> one with <strong>the</strong> highest will<strong>in</strong>gness to pay. Then it would set quality equal to Q 1 and seta <strong>price</strong> equal to A+B+C. The firm would extract all potential consumer surplus and earnA+B+C, which equals total welfare <strong>in</strong> this regime. If we compare with version<strong>in</strong>g, it isobvious that version<strong>in</strong>g would improve welfare. Consumer 1 will still be served, and <strong>the</strong>high quality version generates welfare (consumer surplus plus profits) equal to A+B+C,as is <strong>the</strong> case with no version<strong>in</strong>g. But, <strong>in</strong> addition, <strong>the</strong> consumer with <strong>the</strong> low will<strong>in</strong>gnessto pay buys <strong>the</strong> damaged product at a <strong>price</strong> A 1 . This adds to <strong>the</strong> welfare generated by <strong>the</strong>high quality product, and version<strong>in</strong>g will <strong>the</strong>refore always <strong>in</strong>crease welfare.If <strong>the</strong> firm serves both consumers <strong>in</strong> <strong>the</strong> case with no version<strong>in</strong>g, <strong>the</strong> welfareeffect of version<strong>in</strong>g is more complicated. To illustrate this, let us take <strong>in</strong>to account that<strong>the</strong> number of consumers can differ between segments. So far we have only consideredtwo consumers, consumer 1 and 2. Let us now assume that <strong>the</strong>re are several consumers oftype 1 and several of type 2. In particular, we assume that a fraction γ of <strong>the</strong> consumersare of type 1 (and <strong>the</strong>reby a fraction (1- γ) is of type 2).Which quality would <strong>the</strong> firm choose if it sells only one version and serves bothtypes of consumers? As argued <strong>in</strong> association with Figure 1, <strong>the</strong>re is no additionalrevenue it can earn if it sets quality higher than Q 2 . As long as <strong>the</strong> cost of quality ispositive, even if it is <strong>in</strong>f<strong>in</strong>itesimal small, <strong>the</strong> firm sets quality Q 2 . If so, <strong>the</strong> total surpluswith no version<strong>in</strong>g equals A + γB, where <strong>the</strong> firm earns A and <strong>the</strong> type 1 consumers has aconsumers surplus equal to γB. Then we must compare this total surplus with <strong>the</strong> totalsurplus generated with version<strong>in</strong>g. We have that version<strong>in</strong>g will <strong>in</strong>crease welfare if:(1 – γ)A 1 + γ(A 1 + A 2 + B 2 + C) + γB 1 > A + γBThe first and second expressions on <strong>the</strong> left hand side are <strong>the</strong> profits earned on consumertypes 2 and 1, respectively, while <strong>the</strong> third expression on <strong>the</strong> left hand side is type 1© Steen and Sørgard 8
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