Price Discrimination

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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.

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.

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...
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