Suppose that an airplane basic operating cost is c per a passenger. However, it can price...

Suppose that an airplane basic operating cost is c per a passenger. However, it can price add-ons (better sits, extra beverages, wi-fi) to generate extra fees averaging p̄ from naive type of passangers. A fraction α of customers are naive, and do not foresee these add-ons. The remaining fraction (1 − α) are sophisticated, and can avoid the add-ons at an effort cost of e. For simplicity, assume that the add-ons do not cost anything for the airlines to provide.

(a) Assuming that the flight industry is competitive - so an airline earn zero profits at equilibrium. Calculate the basic price p that the airline will charge.
(b) Calculate the total cost to a sophisticate if he incurs the effort cost e to avoid add-ons, and compare this to the cost if he does not. Under what condition will he put in the effort to avoid add-on charges? Assume for the rest of the question that this condition holds.
(c) Now suppose that the airline decides to stop pricing add-ons separately, and instead adds a compulsory “service fee” of $x that includes free access to beverages, wi-fi, carry-on baggage etc. How much in total will each airline client now pay?
(d) Explain why the sophisticates may not be happy about the new service fees, particularly if the fraction α of naive passengers is large.

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Expert Solution

Rahul Sunny answered 1 year ago

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