Case study Price Discrimination and the Airlines Finding the lowest airfare can be a bewildering experience.

On any given day, there are tens of thousands of fares available. With a full 150-seat aircraft flying between 2 U.S. cities, it would not be uncommon for the passengers to have paid 20 different fares for their seats. In some cases, these differences at least partially reflect amenities associated with higher price tickets. For example, first-class passengers have more leg room and better meals. But in other cases, different prices are charged for the same travel preference. During the summer of 1998, a regular coach rou8nd trip ticket from Chicago San Francisco cost as much as $900, but promotional pricing by the airlines allowed some passengers to make bthe same journey for only $300. Once on board the plane, service was identical-same cramped seats, same bland meals, and same inconvenient rest rooms. For many years, the airlines have used what they call yield management to crease their profits. This practice involves both price discrimination and marketing. The price discrementation component is based on variations in price elastics for different types of customers. Typically, business flyers have less elastic demands because they must meet with suppliers and customers at specific times and in specific locations. Of ten, these trips are made on relatively short notice. Airlines take advantage of this situation by setting higher prices for tickets that do not require advance purchase. In contrast, vacation travelers often choose between many destinations(including some that do not involve air travel) and plan their trips far in advance. Because these discrementationary travel demands are more price sensitive, airlines advertise some seats at lower price if passengers are willing to buy their tickets 7 to 30 days in advance. The marketing aspect of yield management strategies involves determining how many low-priced seats to offer. Altough airlines are required to set at least some seats at the promotional price, they have considerable latitude in determining exactly how seats at the promotional price, they have considerable latitudes in determining exactly how many they will allocate to each flight. Flights that usually are full will not have many low-cost seats, while on those that have a history of excess capacity, airlines will offer many such seats in an attempt to draw additional customers. Determining the most profitable mix of seat prices is a complex and ongoing process for the airlines. Computers are used to continuously reevaluate and alter the optimum composition of prices based on the latest information. It is possible for potential customer to call a travel agent on a Tuesday and be told that there are no promotional fares available on a flight and for another person to call the agent on Wednesday an obtain the low-cost fare on the same flight. Altough airline pricing have the appearance of price discrimination there are other factors that should be considered. Many low-cost fares involve restrications. The ticket may have to be purchased in advance, a Saturday night stay at the location may be required, and the ticket could be nonrefundable. A purchaser of a regular coach-fare ticket does not face these constraints. Thus, it could be argued that the tickets represents different services and that the higher price for the regular fare reflects the additional convenience associated with that ticket.

Types of Price Discrimination

First-Degree Discrimination
Figure shows the demand curve faced by a monopolist. The curve indicates the maximum price that can be obtained for successive units of output. For example, the first unit, Q1, could command a maximum price of P1, the second could be sold for a maximum of P2, and so on. To simplify the discussion, it is assumed that marginal cost is constant and equal to average cost. First-degree price discrimination involves charging the maximum price possible for each unit of output. Thus, the consumer who attaches the greatest value to the product is identified and charged a price of P1. Similarly, the consumers willing to pay P2 for the second unit and P3, for the third are identified and required to pay P2 and P32, respectively.

With first-degree price discrimintation, the profit-maximizing output rate is where marginal cost and demand curves intersect. In figure, this occurs at Qb. At this point, the maximum price that can be obtained for the product is equal to the marginal cost of production. Any attempt to sell more than Qb units would reduce profits, because price would have to be less than marginal cost. Conversely, any rate of of output less than Qb would not maximize profits because the additional units could be sold as shown by the demand curve at prices greater than the marginal cost. First-degree discrimintation is the most extreme form of price discrementation and the most profitable pricing scheme for the firm. Because buyers are charged the maximum price for each unit of output, no consumer surplus remains. As defined in chapter 9, consumer surplus is the difference between the price a consumer is willing to pay and the actual price charged for the good or service. The maximum consumer surplus results when there is no price discrementation and price is set equal to marginal cost. In figure this maximum consumer surplus is shown as the area of the triangle APcB. In contrast with first-degree price discrimintation, there is no consumer surplus because APcB is captured by the firm as economic profit. First-degree discrimintation is not common because it requires that the seller have complete knowledge of the market demand curve and also of the willingness of individual consumers to pay for the product.