Saturday, December 27, 2014

Why transporters and airlines charge different prices during the holidays

Adding more vehicles would cause a holdup.
Source:Wikimedia Commons
Airlines carry two types of passengers – the leisure and the business passenger. Both passengers have several characteristic features which makes passenger segmentation and price discrimination possible. Some of them are that business travelers value travel time higher than leisure travelers and they often book flights close to the time of departure. Therefore, airlines tend to charge business travelers a higher fare than leisure passengers. Also, business travelers are more insensitive to high ticket prices than leisure passengers but have greater awareness of flights, airlines and are more informed on air travel.

During the holidays, based on your time valuations, you could fall into either the leisure or business traveler class.

Airlines can make use of the differences in time valuation between passenger classes to charge different prices. This is called third-degree price discrimination. The graphic below illustrates demand and supply curves for two market segments – business and leisure. It could be seen that monopoly airlines charge higher for business than leisure travel based on the different time valuations of these two segments, and the quantity demanded for leisure travel is higher than for business passengers.

Third-degree price discrimination for a monopoly airline.
Source: Econ 150 Economic Principles and Problems – Micro. Labels have been changed.
Monopoly power and the ability to price discriminate increases welfare loss. The problem is further compounded during the holidays when there is congestion costs factored in. For example, if the demand for air travel by leisure travellers increases during the holidays, airlines might suppress or push up the price for leisure travel based on time valuations by leisure travelers. On the other hand, the increase in travel by leisure passengers creates congestion or delays to business passengers. Recall that business passengers place a higher value on time than the leisure passengers, therefore this externality, congestion costs, increases the actual price of a plane ticket for business travellers. This results in a fall in demand for business travel. This two interdependent effects can be referred to as a network externality. The loss to society, or welfare loss, is of concern to both policy makers and consumers.

Is it possible then to price discriminate in the face of congestion externality and still reduce welfare loss?

According to Achim I. Czerny and Anming Zhang, in a recent paper titled: Third-degree Price Discrimination in the Presence of Congestion Externality, the answer is YES. Provided the monopoly carrier can appropriately segment the market based on time valuations, a third-degree price discrimination would reduce total possible passengers on its flights and hence reduce congestion costs. When compared to the fact that without price discrimination prices overall will rise due to the pressure put on ticket fares by congestion costs during the holidays, price discrimination is better for everyone than the alternative.

Now, you no longer have to wonder why many transporters price discriminate during the holidays.

No comments:

Post a Comment

Your comments here.