Question

Consider an airline trying to sell plane tickets to business travelers and tourists. The airline cannot distinguish between the two at the point of sale, but knows that in general, business travelers have higher willingness to pay for better seats. Let PF and PC be the price of first class and coach tickets respectively. Suppose that business travelers are willing to pay $1000 for a first class seat and $400 for a coach seat, whereas tourists are willing to pay $500 for a first class seat and $300 for a coach seat.

(a) If the airline wants to implement second-degree price discrimination so that business travelers buy first class seats and tourists buy coach seats, what are the incentive compatibility constraints they face?

(b) Using your incentive compatibility constraints, find the price that the airline will charge for a coach seat.

(c) What are the information rents that the airline must leave to business travelers? What is the price of a first class seat?

Answer 1

An airline is trying to sell plane tickets to business travelers and tourists.It is aware that business travelers have higher willingness to pay for better seats.

PF= Price of first class seats

PC= Price of Coach seats

Business travelers are willing to pay $1000 for a first class seat (PF1)

and $400 for a coach seat, (PC1)

whereas tourists are willing to pay $500 for a first class seat (PF2)

and $300 for a coach seat.(PC2)

Ans (a) Second Degree price charging is when a monopolist charges different prices for two different sets of similar products.

In this question, the  business travelers buy first class seats and tourists buy coach seats.

Hence, PF=1000 and PC=300

The incentive compatibility constraint would be that the Price of First class ticket would be at a profit of $500 (PF2-PF1)

And the coach seat would be at a loss of $100(PC1-PC2)

Ans (b) Considering Incentive Compatibility constraints,

The price of Coach should be set at $350.

Since, otherwise the business travelers would feel that they are being charged much more than the class of the airline.

Ans. (c) Information rent is the excess rent paid by buyers than what is needed. Since business travelers are willing to pay $ 1000, we cannot charge such high amount, because the amount acceptable by tourists is $500, which is too low.

Hence for first class tickets, we can charge somewhere between $700 and $800.