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Price Discrimination Essay Sample

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Price Discrimination Essay Sample

I. INTRODUCTION

Price discrimination is observed in most industries. It implies that firms are charging different prices from different consumers, and that the price difference cannot be explained by cost differences. Airline industry is notorious for practicing price discrimination for many years. It is well known that on each flight the passengers have paid different prices, and that in some cases we can observe that the highest price is as much as five times the lowest price. A casual observation would be that there are numerous different versions of an airline ticket to choose among.

You can buy an expensive, flexible ticket. Then you are allowed to reschedule the flight or even cancel it without any costs. Or you can buy a cheap ticket, with many restrictions. For example, a Saturday night stay-over is required and so is advance-purchase. Since each and every passenger can choose between different versions of an air ticket, it is natural to consider the theory of versioning when analyzing the price discrimination in this particular industry and its effect on welfare of consumers.

II. THEORY OF PRICE DISCRIMINATION

Price discrimination is a pricing strategy that charges customers different prices for the same product or service. In perfect price discrimination, the seller will charge each customer the maximum price that he or she is willing to pay. In more common forms of price discrimination, the seller places customers in groups based on certain attributes and charges each group a different price. Price discrimination allows a company to earn higher profits than standard pricing because it allows firms to capture every last dollar of revenue available from each of its customers.

While perfect price discrimination is illegal, when the optimal price is set for every customer, imperfect price discrimination exists. Price discrimination can take various forms. In the literature it is common to distinguish between three different kinds of price discrimination. According to Varian (1996), we have the following definitions: • First degree: The seller charges a different price for each unit, so that the price of each unit equals maximum willingness to pay.

• Second degree: Each consumer faces the same price schedule, but the schedule involves different prices for different amounts of the good purchased.

• Third degree: Different consumers are charged different prices, but each consumer pays a constant price for each unit of the good bought. Versioning fit into this definition of price discrimination. Versioning implies that all consumers are facing the same price schedule. They can choose to buy an expensive, high quality version or a cheap, low quality version. Technically, this is an example of second degree price discrimination. The consumers pay different prices for different amount of quality of the good purchased.

III. VERSIONING

The most common form of price discrimination used by airline companies is versioning. Versioning is a practice in which a company produces different models of the same product, and then charges different prices for each model. Versioning a product gives the consumer the option of purchasing a higher valued model for more money or a lower valued model for less money. In this way, the business is attempting to attract higher prices based on the value a customer perceives. The high quality version is the flexible ticket, where you can reschedule your flight at any time and even cancel the flight without any costs attached to it.

The damaged version is a so called restrictive ticket. There can be several restrictions on it. For example, Saturday night stay-over, advance purchase and no flexibility concerning rescheduling of the flight. Note that the main reason for damaging the product was to make it less attractive for the consumer with the high willingness to pay. This is obviously the driving force in the airline industry when they introduce a particular restrictive ticket. All three restrictions mentioned above are important for the business travelers and damages the product from their point of view, but not so important for the leisure traveler.

For example, a Saturday night stay-over restriction implies that the business traveler – who typically travels during the week – finds such a version unattractive. A leisure traveler, on the other hand, might prefer to travel in the weekend and then such a restriction is not a problem at all. The observed behavior is consistent with the findings in Holmes (1993). In their theoretical study they find that a monopoly airline will offer tickets with restrictions to ‘weed out’ consumers with high valuation of time. There are some studies that tests for how price discrimination in the airline industry is affected by competition.

Some studies find that the average price level in the airline industry increases with market concentration (Borenstein and Rose and Rose, 1994; Morrison and Winston, 1990). But this does not say anything about whether the price discrimination is more prevalent in a competitive setting. Borenstein and Rose (1994) find that price dispersion in the airline industry is larger in a competitive market situation than in a monopoly market situation. This suggests that firms price discriminate more in a competitive setting. Stavins (2001) tests more directly for how versioning is affected by competition.

She considers two kinds of product damaging: Saturday night stay-over requirements and advance-purchase requirements. By using data from the U.S. airline industry for 1995, she tests for how those two restrictions affect the discounts. Discounts can be seen as the difference between the price of the high quality version and the price of the damaged version. It is found that both restrictions lead to lower airfares.

Less obviously, though, is how competition affects the discount. She finds that the discounts are larger in markets with low market concentration, and this is true both for the Saturday night stay-over restriction and the advance-purchase restriction. She concludes as follows: ‘The results are consistent with the hypothesis that, as more carriers operate on a given route, the carriers’ competition for consumers with higher price elasticity of demand increases, while fares charged to consumers with inelastic demand stay high.” (Stavins, 2001, p. 202).

Her results are consistent with the results found in the Norwegian airline industry (see Steen and Sørgard, 2001). Using data for the period 1996-2001, it was found that a shift from monopoly to duopoly had no effect on the price of the high quality version flexible air ticket, labeled C-class ). On the other hand, a shift from monopoly to duopoly had a price-decreasing effect – although of minor magnitude – on the price of the damaged product (the restrictive ticket, labeled the M-class).

The theory of price discrimination is primarily concerned with a situation with a monopoly firm. Let us for the moment consider a situation with only one firm. To simplify further, we assume that there are only two consumers. Each of them demands one unit. The willingness to pay for each of them for this unit depends on the quality of the good. To relate the setting to the airline industry, we may denote consumer 1 a business passenger and consumer 2 a leisure passenger. In Figure 1 we have illustrated the marginal willingness to pay for each of the consumers for different levels of the quality of the good. Figure 1 Quality versus marginal willingness to pay

Consumer 1 Demand

Marginal B Consumer 2 Demand
willingness
to pay A

C
Q2 Q1

The area below the marginal-willingness-to-pay curve denotes the total willingness to pay. If quality is Q1 (or higher), then consumer 1 is willing to pay A+B+C for the good. If the quality of the good equals Q2, then consumer 1 is willing to pay A+B while consumer 2 is willing to pay A.

We assume that it is not more costly to produce a high quality than a low quality  product. As we will explain later, typically the low quality version is a damaged version  of the high quality version (called damaging product). If so, it is not obvious that the high  quality version is the most costly one to produce. If we assume that there are no costs associated with producing a high quality instead of a low quality version, what then would the firm do? It would then produce a version with high quality, which in Figure 1 is quality Q1, and sell it at a price of A to consumer 2 and A+B+C to consumer 1. Then the firm would extract all potential consumer surplus, and it would earn 2A+B+C. But it is obvious that this is unrealistic. If the consumers can choose, then both consumers 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 low price product. The low price product cannibalizes the earnings from the most valuable market segment. How could the firm avoid such a cannibalization? One possible solution is, as indicated above, product damaging. Let us assume that the high quality version (quality Q1) is still produced. Furthermore, let us assume that the quality of the second version equals Q2, and thus can be considered as a damaged product. This implies that consumer 2 still has a willingness to pay equal to A for the damaged version. Consumer 1, on the other hand, has a higher willingness to pay for quality. He is willing to pay A+B for the damaged version.

What if the firm now sets price A on the damaged good? Then it extracts all potential consumer surplus from consumer 2. If so, which price should it set on the high quality version? Consumer 1 has a high willingness to pay, so the firm would prefer that he buys the high quality version.

But what is the maximum price the firm can charge on the high quality version? If consumer 1 buys the damaged product, it pays A and receives a consumer surplus equal to B. Then the firm must set a price on the high quality product so that consumer 1 receives at least B in consumer surplus. We see from Figure 1 that the firm can charge (slightly less than) A+C for the high quality product, and consumer 1 will then choose the ‘right’ version. If so, the firm earns 2A + C. By damaging one version of the product the firm has increased its earning with C.

Why has such a strategy been profitable for the firm? It does not earn more from  the consumer with a low willingness to pay, despite the fact that the damaged version is meant for that particular consumer. The point is that the consumer with the high willingness to pay has a less attractive alternative. It implies that the firm can charge a higher price on the high quality version, and still be sure that consumer 1 buys the high quality version.

IV. CONCLUSION

Versioning implies that the airline offers different versions of its product, and the consumer can choose between them. The high quality version is a flexible ticket, where the passenger can reschedule and even cancel the flight whenever it wants. The low quality version is a restricted ticket, typically with a Saturday night stay-over and advance purchase requirement.

In the theoretical literature the restricted ticket is called a damaged product. The airline offers a damaged product because it then makes this low quality version less attractive for the business traveler. It enables them to charge a high price for the flexible ticket, and still serve the passengers with a low willingness to pay by offering them a damaged product. This leads to increased output, and increased output may lead to higher frequency.

Apparently, damaging a product is detrimental to welfare since the airlines offer an inferior product. But we argue that the net effect of versioning in the airline industry is probably positive. The product damaging is harmful for those who do not buy the product but rather the high quality product – the business travelers – but probably not very harmful to those who actually buy that version. For example, a leisure traveler might travel during the weekend and then a Saturday night stay-over is not harmful at all.

Moreover, the alternative to versioning might be that no low quality version would be offered. If so, the segment with low willingness to pay would have been hurt by a shift from versioning to no versioning.

Finally, empirical studies indicate that competition leads to a cheaper damaged product. Since this segment is typically quite price elastic, it would lead to a substantial output increase and thereby a substantial welfare increase. Therefore, versioning is welfare improving, especially in a competitive setting.

Bibliography
Borenstein, S. and N. L. Rose (1994): “Competition and Price Dispersion in the U.S.
Airline Industry”, Journal of Political Economy, 102: 653-683.

Carns, R. D. og J. W. Galbraith (1990): “Artificial Compatibility, Barriers to Entry, and
Frequent Flyer Programs”, Canadian Journal of Economics, 23: 807-16.

Dana, J. D. (1998): “Advance-Purchase Discounts and Price Discrimination in
Competitive Markets”, Journal of Political Economy, 106: 395-422.

Deneckere, R. J. and R. P. McAfee (1996): “Damaged Goods”, Journal of Economics &
Management Strategy, 5: 149-174.

Holmes, T. J. (1989): ‘The Effects of Third-Degree Price Discrimination in Oligopoly’,
American Economic Review, 79: 244-250.

Morrison, S. A. and C. Winston (1990): ‘The Dynamics of Airline Pricing and Competition’, American Economic Review, 80: 389-393.
Stavins, J. (2001): ‘Price Discrimination in the Airline Markets: The Effect of Market
Concentration’, Review of Economics and Statistics, 83: 200-202.

Varian, H. (1996): ’Differential Pricing and Efficiency’, First Monday, Vol.1 No.2 –
August 5th. 1996, http://www.firstmonday.dk/issues/issue2/different/index.htmlarian.

Varian, H. (2000): ‘Versioning Information Goods’, chapter in B. Kahin and H. Varian
(eds.): Internet Publishing and Beyond, The MIT Press.

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