Page 536 - Microeconomics, Fourth Edition

c12capturingsurplus.qxd 7/22/10 10:41 AM Page 510

510 CHAPTER 12 CAPTURING SURPLUS

APPLICA TION 12.5
Fencing in the Price of Flight
costs of service are similar, the inverse elasticity rule
suggests that an airline would like to charge a higher
Airlines typically sell tickets at a variety of fares, as we price for business travelers.
saw at the beginning of the chapter when we looked How does the airline implement price discrimina-
at American Airlines’ flights between Chicago and tion? Although it knows that there are different
Brussels. Third-degree price discrimination in one of types of travelers, it does not know the specific type
the strategies airlines use to fill the plane with travel- of any customer. It could ask the customer to reveal
ers in the most profitable way. Airlines often charge his or her type with a direct question, “Are you trav-
different prices for seats in the same class of service, eling on business or pleasure?” But if travelers knew
such as coach class, even though the marginal cost of they would be quoted a lower price by identifying
serving a passenger is about the same for all passen- themselves as vacation travelers, the response would
gers. Different customers are willing to pay different often not be truthful. Economists say that informa-
amounts for tickets. For example, people traveling on tion is asymmetric: The customer knows his or her
vacation often can book their tickets weeks or even type, but the airline does not.
months in advance of the flight, and they are willing How does the airline design a mechanism to imple-
to shop around for the best price. They may even de- ment price discrimination in the face of the informa-
cide to choose their destinations based on the avail- tional asymmetry? It builds a set of fences. Restrictions
ability of relatively inexpensive tickets. Thus, vacation on fares are ways of “degrading” or “damaging” prod-
travelers are usually quite sensitive to price, especially uct quality. A nonrefundable fare is of lower quality
if the vacation involves the whole family. In contrast, than a refundable fare. A fare that requires that you to
passengers traveling on business are often less sensi- pay for checked baggage is also of lower quality. So are
tive to the price of the ticket. When business requires fares that require you to stay over a Saturday night or
that a passenger be in London for an important meet- to purchase the ticket 14 days in advance. In building
ing on Monday at 8:00 AM, the traveler will make the fences, the airline is creating different versions of its
trip even if the fare is expensive. product, with low-quality, low-price tickets that appeal
An airline knows that it serves different types of to price-sensitive customers, and high-quality, high-
customers, including business customers with a typi- price tickets that appeal to less price-sensitive cus-
cally relatively inelastic demand, and vacation travel- tomers. Customers are then induced to self-select into
ers with relatively elastic demand. Since the marginal the product type designed for them.

involve a higher price and/or a lower quality), while quality-price pairs located to the
southeast of point A are preferred to point A by group alpha consumers.
The line labeled u is an indifference curve for group beta consumers (high price
B
sensitivity and low quality sensitivity) and can be interpreted the same way as u .
A
Notice that at the point at which u and u cross, u is steeper than u . This illustrates
A
B
B
A
that starting from a given quality-price offer, group alpha consumers are willing to pay
more for a given increment to quality than are the consumers in group beta.
The shaded area that lies to the east of u and the west of u is critical for build-
B
A
ing the desired fence. Consumers in group beta prefer any quality-price offer in this
range to the offer at point B. Thus, consumers in group beta are made better off if the
firm makes the low-price offer point C rather than point B. Moreover, group beta con-
sumers prefer offer C to offer A.
By contrast, consumers in group alpha prefer quality-price offer A to quality-
price offer C. Thus, they will purchase the high-price–high-quality version of the